Two weeks ago, in “Ball Back in OPEC’s Court,” I previewed the oil exporters’ June meeting in Vienna. OPEC shook the oil markets last November when it refused to cut production to help shore up prices, as many had expected, choosing instead to defend market share against the surge of supply from U.S. shale producers.

The crude oil price plunge accelerated following that November meeting, and a look at the U.S. rig count provides a pretty clear picture of its impact on U.S. shale drillers:


Rig counts went into freefall after it became clear that OPEC was not interested in helping keep the price of oil high for the benefit of rapidly expanding shale oil producers. While that approach hurt OPEC’s income in the short term, it also served the purpose of decimating rig counts in the shale oil fields. As a result, the production gains from U.S. oil producers have already begun to slow.

There had been much speculation about what OPEC might do now that one of its key objectives had been achieved. Most believed it wouldn’t do anything drastic enough to shake up the oil markets again. I placed the odds of either a big cut or a production increase at under 10%. I estimated a 40% chance that production would be left unchanged, and a somewhat greater than 50% probability of a modest production cut.

There was risk either way. Leaving production unchanged ran the risk of sending crude prices back toward $40/bbl. This would the hurt poorer members of OPEC, which have historically favored higher prices. On the other hand, low prices would continue to slow down the U.S. shale oil boom.

A modest production cut would have satisfied OPEC’s poorer countries, but would have also likely boosted oil prices toward $70/bbl. This would start to bring marginal shale oil production back online.

There were also variations of these two outcomes. OPEC could have announced production cuts but not actually made any. The organization is notorious for exceeding its production quotas, so that wouldn’t have been a big surprise. Or, it could have left production unchanged, while attempting to talk up the demand side of the equation in order to limit a marker overreaction. That is in fact exactly what OPEC did.

In announcing a decision to leave production unchanged — the same decision that led to last winter’s plunge toward $40/bbl — OPEC noted that world oil demand is forecast to increase in 2015 and in 2016, with growth driven by developing countries. On the supply side, non-OPEC growth in 2015 is expected to drop below 700,000 barrels per day, about one-third of the supply growth in 2014. With supplies expected to tighten in the months ahead, OPEC therefore saw no need to cut production.

While the exporters’ club is certainly known for self-serving statements, I believe it is correct here in noting the trajectory of supply and demand in the months ahead. Shale oil production is going to continue to slow, while global demand growth marches on. By leaving the production quotas unchanged OPEC is letting growing demand catch up to North American output growth, and counting on this to prevent an extended slump.

The odds look good that OPEC will also have to accommodate production from Iran should sanctions soon be lifted as anticipated. But this won’t impact the global supply/demand balance for a few months, and is something that will probably be a big topic at OPEC’s next meeting in December.

How should investors play this news? It is unlikely now that there will be a near-term catalyst for higher oil prices. I expect oil to trade in the $50-$65/bbl range for the summer and probably headed into OPEC’s next meeting. However, should shale oil production decline significantly this summer prices would probably head back above $65/bbl.

Investors will want to remain wary of small, leveraged producers while this correction plays out. There have already been bankruptcies resulting from the downturn in oil prices, and OPEC’s most recent decision makes it likely that there will be more. Larger, more efficient producers such as EOG (NYSE: EOG) and ConocoPhillips (NYSE: COP) will get through this turbulence without too much difficulty, but once the market does turn up they will also have less upside than smaller producers like Oasis Petroleum (NYSE: OAS) or Sanchez Energy (NYSE: SN). For the foreseeable future, I would consider the small producers appropriate only for the most  aggressive investors, as there is likely to be significant volatility before the global crude glut is resolved.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Plenty of Pain in Propane

While crude continues to hang around $60 a barrel following its spring rally, another energy commodity just tagged a 13-year low Monday amid a huge glut caused by burgeoning domestic output and softer overseas demand.

The spot price of propane at the Mont Belvieu hub on the Texas coast hit 31 cents a gallon Monday as exports continued to lag after years of rapid growth, while inventories approached last year’s record.

This is bad news for liquids-rich natural gas producers like EQT (NYSE: EQT) and gas processors like Targa Resources (NYSE: TRGP), which get paid partially with some of their NGL processing proceeds. Conversely, it’s a boon for propane distributors like AmeriGas Partners (NYSE: APU) and UGI (NYSE: UGI), which stand to benefit from improved demand and expanding margins in much the same way petroleum fuel distributors did last fall when crude slumped.

Keep in mind, though, that propane prices are notoriously volatile and may not stay this low for long. We’ll have more on the implications of the propane crash in the next issue of The Energy Strategist.

— Igor Greenwald