The Opec meeting: days of market turm-Oil

Several investors have kept an eye open on oil this week putting all their hopes in the long-awaited OPEC meeting held on Thursday.
Opening this week at $80.50 per barrel, the decisions of the OPEC meeting provoked an intraday drop of 6.65 percentage points in Brent crude prices on Thursday, with the oil price reaching a 4 year low on Friday at $69.78  and closing at $70.25 per barrel, as one can see in the chart below.

The price of Brent crude fell as the chances of Opec members agreeing on supply cuts suddenly looked remote on Thursday and the Vienna meeting which will be held on the 5^th June 2015 is starting to become crucial, even though its remoteness raises more than obvious concerns.

In particular, given that with great probability some parts of the market have been pricing in the chance of a cut, prices could fall further.

This Thursday Opec representatives showed different visions and decisions: Rafael Ramirez, Venezuela foreign minister, Youcef Yousfi, Algeria’s minister of energy  and Iran representative all agreed on production cuts. José Maria Botelho de Vasconcelos, Angola’s minister of petroleum showed concerns about oversupply, while Saudi Arabia, Opec’s largest producer and effective leader, decided to let the market readjust the oil prices giving up its traditional role of balance in oil market by reducing or increasing output. In fact low cost Gulf producers, Saudi Arabia, UAE, Qatar and Kuwait are more willing (and more able) to deal with a period of lower prices in order to keep market share in the long run. In the end Opec decided to leave its output ceiling at 30million barrels per day causing an overall drop of almost 9% in Brent price in the following days; the decision was partially justified by the fact that many countries were not prepared to make any cuts themselves.

The consequences of Opec decision did not solely result in a dramatic drop of Brent price, but also in the depreciation of smaller producers’ currencies such as the ruble that touched record lows against the dollar trading at R48.61 after Opec meeting and Nigerian Naira whose central bank is fighting to keep its devaluation within the 8% band.

The concrete evidence of suffering from certain Opec producers due to the falling oil prices and the Gulf’s decision not to cut output makes market participants think that, if not done on purpose, this strategy might force smaller players to exit the market.

A closer look at specifics

The issue at hand is whether US oil companies still manage to make a profit at specific levels of oil prices, and there has been much speculation around what the possible break-even point actually is. In the past weeks we have seen smaller oil companies striving to stay afloat in the current volatile environment, their stocks plunging day by day. Looking into the issue with a little more detail, many American facilities producing oil from Texas’s Eagle Ford and Permian strata would still manage to earn a profit at prices of $40-$50 per barrel. Nevertheless, it is new projects and investments that would find it hard to kick-off if prices were to lower even more, given unattractiveness of potential margins. To what extent can American companies still manage to earn a profit out of their costly fracking extractions?
By observing the chart below made by Bloomberg New Energy Finance, we notice that most companies would still be profitable below 80, and still another great amount below 70. These numbers –as the British would say- are to be taken with a pinch of salt, since not only have the financial markets been volatile this week, but also the media markets which have filled the news with the most diverse range of break-even points, price forecasts and so on. One piece of information that seems widely accepted though, is that only 4 percent of U.S. shale output needs prices above the $80/barrel threshold. Putting this into context, it definitely looks like American companies, given also their ever-increasing production in the past year, are much better positioned than members of the Opec right now. A quick comparison can be made with the break-even point for Opec members in the chart further down.

Among OPEC’s members, the only countries which will be able to balance their budgets and survive this last part of the year unharmed are Qatar and Kuwait. The likes of the Saudis will manage to withstand the crisis, given their 740b dollars ready day funds to fall back on. The Saudis, Kuwaitis and Qataris have all set their budget at estimates of 80-90 $ /barrel, so this would explain why they still prefer market forces to govern the price at which oil trades, since they can back their current losses with ample financial reserves, without losing market share.

How to play the markets

The world’s oil companies, in the light of the current macroeconomic scenario, have had to take on additional debt and sell assets in the past months so as to cover the shortfall in cash that most of the sector is presently experiencing. With WTI and Brent currently having trader this week below $70, one should not only take into consideration the effects of these events on stocks, but also on the junk bond and leveraged loan markets. Analysts believe that corporate bond from the energy sector is still overpriced when compared with the shortfall in equity markets in the past months. Thus we would recommend shorting oil companies’ debt. For instance, looking at BP 4% bonds expiring in the end of December, they are still trading above Par at 100.23 (rather unusual given many of the same kind at prices close to 94) and may experience further slides in the coming week, given the macro fundamentals which we have extensively talked about.
Also, a trade that has proved worthy in the much volatile past weeks has been buying straddles. Let us remember that when buying a straddle, one is betting on the fact that volatility will increase and the current price will not stay where it currently is. One popular one has been the March $75 straddle, which should be updated now to the current market prices of Brent Crude, closing on Friday at 70.25, at a 4 year low. Strike prices of $70/barrel are therefore recommended.

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