DBO - Saudi Arabia's Oil Production Cuts And How To Profit From Them

2023-06-05 17:22:57 ET

Summary

• Saudi Arabia announced voluntary cuts of 1.5 million barrels per day in oil production, potentially raising crude oil prices and impacting global markets.
• The cuts aim to control market volatility, boost oil export profits, and reduce excess global inventories, but verification of production cuts remains a challenge.
• Short-term opportunities for investors in US oil and gas may arise, but uncertainty looms over the market due to OPEC+ production decisions.
• US investors would do well to focus on undervalued names in upstream and downstream. Midstream will be more insulated from price increases.

OPEC+ Meeting Recap

There was a ton of speculation leading up to Sunday's OPEC+ meeting about whether the group would announce more cuts, and you can see that reflected in the volatility in last week's crude oil markets. But this does present US investors with a short-term opportunity in the energy markets, at least through 2023, and potentially part of 2024.

Investors, traders, and really the rest of the world, in general, are all scratching their heads a bit after the OPEC+ meeting that was held on Sunday. For years and years, Saudi Arabia has vowed to intervene in the oil market only with other OPEC+ major players. So this was pretty unexpected for Saudi Arabia deciding to go rogue and announce major solo production cuts in this fashion.

The last time they tried the solo strategy was in the early 1980s - and it notoriously failed in grand fashion. But that's exactly what happened on Sunday, where the playbook was tossed aside, and Saudi Arabia announced that they are now voluntarily going to cut 1.5 million barrels per day of oil production this year. The new announced cuts are intended to be only for July, but the Saudis indicated it may be extended, if needed.

Here's the quick recap and key takeaways that you need to know from the OPEC+ announcement:

• Saudi Arabia is extending 500k barrel per day production cuts until 2024.
• Saudi Arabia is cutting an additional 1 million barrels per day voluntarily.
• Saudi Arabia announced it will reduce output by 10% in July to output levels of 9 million barrels per day - the lowest production levels seen from Saudi Arabia in well over a decade.
• Iraq is extended 211k barrels per day cuts until 2024.
• Russia is extending voluntary production cuts until 2024.
• OPEC+ agrees to new production target of 40.5 million barrels per day.

This all comes after Saudi Arabia told oil short sellers to "watch out" last week, as the minister has repeatedly sought to hurt bearish oil speculators. Prince Abdulaziz even went as far as to say that the cut highlighted how the kingdom "will do whatever is necessary to bring stability to this market." And I think it's pretty clear that by "stability" they clearly mean "higher oil prices."

I hate to say it, but OPEC+ is not messing around this time. Saudi Arabia is making it very clear to the rest of the world that they are still in control of the crude oil market and reminding the world of how powerful the OPEC+ organization really is.

These kinds of cuts primarily aim to control market volatility, boost increased oil export profits for exporting nations, and of course, reduce excess global inventories. So why didn't WTI crude oil prices jump up higher after all these production cut announcements? After all, the last time OPEC+ announced a cut we went over $80 per barrel (April 3, 2023).

Well, OPEC+ has a policy of "trust but verify" within its member nations. This requires an independent media doing the verifying of each country sticking to their production cuts. Unfortunately, the verification process isn't always cut and dry, and you are seeing that reflected in the markets.

While West Texas Intermediate (Futures CL) initially jumped 5% on the production cut news early Monday morning in the session, the gains were quickly pared to settle at a roughly 1.5% - 2% increase in both Brent Crude and WTI crude pricing.

What To Make Of The Meeting?

Saudi Arabia is essentially doubling down after its previous round of production cuts (announced just two months ago) failed to deliver a price rally because weak economic data from China has weighed heavily on oil futures and global markets in general.

And while this effort to prop up commodity prices ultimately requires a short-term sacrifice of market share - global oil demand is forecast to hit a record high this year and so Saudi Arabia should be able to immediately resume production and recapture that market share at a higher price floor levels than right now once supply and demand stabilizes.

It's no secret on the world stage that the Biden Administration has depleted the U.S. strategic reserve crude oil stockpiles during his time in office. What most people in this country don't understand is that while it may have been short-term relief for consumers at the time of soaring prices, this move by the Biden Administration has potentially cost OPEC+ billions of dollars in revenue and market share.

It's also no secret that this administration has committed to refilling strategic oil reserves at the $62-$72 per barrel range at the end of this year. However, one of Saudi Arabia's goals throughout this could be to weaken US energy security. If Saudi Arabia can prop up crude oil pricing long enough, the United States will continue to have depleted reserves and will be left in the dust once demand ultimately rises again.

In other words, if oil prices do return to around the $80 to $100 per barrel level, we can expect our strategic reserves to remain depleted. This means that Americans will ultimately cede a large portion of their share of the crude oil market when global supply and demand finally returns to pre-COVID levels.

What This Means For US Markets

I think the biggest guaranteed takeaway from this that every investor should be aware of is that price floors for crude oil just went up significantly through the end of the year. What might have been a $55 - $60 per barrel price floor without the recent OPEC+ cuts, just jumped to what I think will be a $65 - $70 per barrel price floor for the remainder of 2023. Overall, these decisions are a short-term win for US oil and gas, but the uncertainty looming over the market may temper any major gains potentially had.

In the short term, major producers in US shale plays are celebrating as crude oil prices should start to rise significantly as global demand continues to increase coming into the summer months. Upstream and downstream companies in the United States should see a short-term rise in value and revenue with higher commodity pricing. Midstream companies that are more shielded from commodity price volatility also will see an uptick in volume in their more shielded fee-based business segments.

So, in the short term, I expect the major players of all segments of US oil and gas to enjoy increased revenues and drilling activity, but heavy optimism may be overshadowed by OPEC+ production uncertainty and the fact that they can crash the market at any given time.

There will be a point, likely in early 2024, where Saudi Arabia could flood the market with oversupply, dropping prices temporarily to bottom out loose-spending US producers to recapture even more of the market share than they had previously sacrificed with higher commodity price floors.

Investors should look to invest in upstream companies that are exposed to the most favorable shale plays in terms of breakeven pricing. Shale plays like the Permian Basin (Delaware Basin within the Permian Basin specifically) will become all the rage as Saudi Arabia and other OPEC+ member production cuts open the door for U.S. shale producers to increase production levels to potentially capture some of the export market.

These companies will reap the biggest rewards from the OPEC+ recent supply cut decisions. Refineries and other commodity-pricing dependent downstream companies also will likely benefit in the short term as pricing for refined consumer products will likely spike and demand should continue to rise as more Americans start returning to the office and China continues to recover after stringent COVID lockdown measures.

Looking at this objectively - Saudi Arabia did a fantastic job reasserting itself as the unquestioned global powerhouse in crude oil. Leaving the market with a looming uncertainty about the future of its production levels was a little bit of a flex of the country's muscles, showing just how much they really do control the oil market.

You can see that in the immediate 5% spike in WTI followed by the "wait a minute" moment from world markets that resulted in paring gains to below 2% from such a monumental and surprising cut. The announced production cuts were a sort of self-righteous short-term sacrifice that ultimately has left them with more power (be it marred with uncertainty).

Conclusion

All in all, investors have an opportunity in the short term to reap the rewards of what should be sustained higher commodity prices through the end of the year. We all know that volatility breeds opportunity - and Saudi Arabia just cemented in additional volatility.

There will be plenty of money to be made on oil and gas investments, but be careful not to get caught holding the bag when price corrections happen. Pay attention to the buzz leading up to major OPEC meetings, and be ready to liquidate your position quickly when the time comes.

Try to focus on buying undervalued producers in low breakeven basins, like the Permian (again, specifically Delaware). Midstreams will be pretty insulated from these movements. Downstreams will again profit in the short term from the potentially increased pricing floor for crude.

And, as always, set an alert for those crude prices.

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