As widely reported, the proliferation of US shale oil in recent years has had two main consequences: greater crude supply and lower production costs. These factors have led many energy analysts to call for oil prices that are “lower for longer,” a phrase that is easy to remember and fits a bearish tone some pundits seek to convey. Still, the CEO of Royal Dutch Shell Plc took it a step further last week when he said the company was preparing for prices being “lower forever.” This likely represents conservative and possibly prudent planning, but also a duration that exceeds the forecast period for even the longest-term investor.
Since commodities (like oil) are of course priced in exact figures, it should be noted that “lower” and “longer” are comparative terms. “Lower” than what? Current prices or the $100+/barrel crude price of few years ago? The latter seems a fairly safe assumption to us. And “longer” than what? The 10-year production plan of Pioneer Natural Resources (PXD), the 12-month period commonly used for target prices by sellside analysts, or the even shorter investment horizons of many hedge fund managers? Again, a lot of variation there.
We concur with the conclusion of deflationary impacts that stem from an abundance of shale oil now readily accessible to US E&P companies and from producers’ enhanced abilities to lower costs via longer laterals, closer fracks, and increased use of technology in general. Still, “lower” doesn’t have to mean prices approaching the $27/barrel depths experienced in early 2016. Rather, a constructive “lower” could be a relatively muted price range, such as the low $40s to mid-$50s/barrel seen thus far in 2017. Under such a range, many low-cost companies can still enjoy healthy margins, and moves from the lower-end to the higher-end of the range still represent significant changes in crude prices, and in turn company earnings.
Additionally, the idea of “longer” seems quite arbitrary. While giving credence to the operating improvements mentioned above, we are not willing to proclaim that oil prices will NEVER again experience a highly inflationary environment. In our view, there are simply too many variables (geopolitics, infrastructure constraints, Wall Street financing, OPEC, etc.) to make such a statement. Moreover, such factors are also likely to have considerable influence on near-term prices, possibly countering the trend of shale-induced deflation. Finally, in today’s environment of compressed investment horizons for many investors, the idea of “longer” may be a lot “shorter” than it used to be.
Most importantly, concluding prices will be “lower for longer” could be detrimental to investment returns. Taking this stance risks complacency among investors who reason they can safely underweight the sector as energy equities continue to reflect subdued crude prices for the foreseeable future. The problem with this is the potential to miss important inflection points for the sector and, as mentioned above, many companies may do just fine with prices “lower” than they once required. Perhaps cautious analysts should consider shifting to a more flexible “lower for now” opinion. At least this would appear to give appropriate reverence to the many variables influencing the dynamic energy sector.