Crude oil prices have fallen rapidly to levels not seen in more than two years, sounding alarm bells among investors. In this paper, we address our view on how the oil market arrived at this position, the dynamics under current and future consideration, and how Western Asset, as longer-term value investors, views capital market dislocation.
At the heart of our ongoing analyses is an understanding that current oil prices are generally not an accurate predictor of future oil prices. Rather, we believe a close examination of supply and demand fundamentals offers the best indication of the direction of long-term oil prices.
The energy industry is a highly cyclical one that can result in vicious price corrections, short-term volatility at lower levels and broad industry contractions, typically giving way to medium- to longer-term price stabilization at higher levels as growth in global oil demand resumes.
How Did We Get Here?
The drop in oil prices is the result of a confluence of events, but oversupply is the primary reason. For several years now, US supplies have grown rapidly as technological developments have made it possible to extract shale oil from previously inaccessible tight rock, opening up a new domestic source of energy for US-based companies and consumers. Furthermore, these advances in drilling technology have allowed for greater efficiencies in the production process, resulting in accelerated production timelines. These industry advances have been facilitated by easier access to both debt and equity capital, enabling rapid expansion of total US production over the last five years.
Stabilization Expected Over the Long Term
We believe US oil producers will exhibit a swift and rational response to lower commodity prices, opting to aggressively rein in near-term capital expenditures, which should have a positive impact on the current supply/demand imbalance over the course of 2015. While current supply/demand fundamentals are weak, we believe the challenges are largely transitory and can be addressed through restricted supply and stronger demand in the long term.
Implications for Investors
In the short term, energy market fundamentals, in our view, will remain challenged. Prices can overshoot to the downside as the market searches for a bottom. However, we believe this volatility creates opportunities for investors. Consistent with prior cycles, we expect US energy producers to rationally cut capital spending budgets to reflect lower future cash flow expectations and lower reinvestment economics, instead focusing on liquidity and capital preservation. In addition, energy companies will likely use market dislocations to reposition asset bases for the long term, opening the door to increased M&A activity. As companies focus on preserving liquidity and strengthening balance sheets, investors may have an opportunity to capitalize on dislocations in security valuations. Although production growth will likely still occur—albeit at a slower pace—lower service cost inflation will follow at a lag. With oil at such low price levels, new projects are unlikely to get approved, thereby removing sources of future supply. We believe rational behavior will return in this new price reality; the longer prices stay low, the more aggressive the producer response will likely be.
For more, read “Oil Market Volatility: An Opportunity for Value Investors,” Western Asset
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