The markets went into turmoil after last week's announcement from OPEC that it would not cut production to stem the price plunge that has taken crude down more than 35 per cent in recent months.
The news should not have come as a surprise. The Saudis had sent clear signals prior to the meeting in Vienna that they were prepared to let supply and demand forces dictate prices and weren't willing to surrender market share to help out such beleaguered OPEC partners as Venezuela. At the conclusion of the meeting, Saudi Oil Minister Ali al-Naimi called the stand-pat result "a great decision". The cartel has a production ceiling of 30 million barrels a day (although it has been exceeding that lately), of which Saudi Arabia generates about one-third.
Judging by the reaction that followed the announcement, it seems a lot of people didn't believe the advance indicators. In the past, OPEC almost always responded to falling oil prices by cutting back production. But this time it's different.
OPEC no longer has the clout it once had. Only about one-third of the world's output comes from member nations. The emergence of Russia as an energy superpower and the startling rise in U.S. shale oil production has changed everything. In fact, U.S. production is now close to that of Saudi Arabia, something no one could have imagined a few years ago.
In this new world, it appears the Saudis have embarked on a scorched earth policy through long-term price-cutting. Call it the oil industry's version of Black Friday. Their strategy appears to be to put financial pressure on high-cost producers, especially in the U.S., with the goal of slowing new development and perhaps forcing the shut down of some wells, at least temporarily. The end game is to increase, or at least maintain, market share and restore some of their rapidly declining U.S. export market.
That could mean low oil prices for at least a year and perhaps longer. And the Saudi plan may fail. According to the International Energy Agency, most of the production from the Bakken formation, which is mainly in North Dakota but extends into Canada, is profitable down to around $42 a barrel (prices in U.S. dollars). In fact, the IEA has projected that U.S. production will increase by almost one million barrels a day in 2015.
Production is already exceeding global demand by a considerable amount. The latest report from the U.S. Energy Information Administration predicts that oil stockpiles will build at a rate of 400,000 barrels per day through the rest of this year and into 2015 at current production levels. Any increase in U.S. output will add to that imbalance. The obvious result would be even lower prices than we're seeing now.
After the news from Vienna, the price of West Texas Intermediate crude dropped below $70, closing Friday at $66.15, the lowest it has been since 2010. The shares of energy companies tumbled, in some cases by more than 10 per cent. The loonie and other petro-currencies were hammered. The TSX went into a deep dive, falling 116 points on Thursday and another 178 points on Friday. By the end of the week, the energy sector had lost 13.7 per cent and was down 15.6 per cent for 2014.
There could be more bad news still to come for energy producers and investors. Some oil industry analysts believe that with the OPEC card no longer in play, the price of crude could fall as low as $60. That would be great news for drivers and for industries that are big energy consumers, such as the airlines. But if you own any oil and gas stocks, it looks like you're in for a long grind.
That said, I would not be a seller in these circumstances, unless you need some capital losses for income tax purposes. Despite the wishes of environmentalists, oil is going to be our dominant energy source for many years to come. We've seen this kind of market turbulence before – in fact the industry is highly vulnerable to boom/bust cycles. Many people forget that at the turn of this century, the price of crude was about $25 a barrel. By mid-2008, Brent North Sea crude was trading at over $145 a barrel and economists were predicting the price would hit $200 before long.
That never happened. Instead, the world went into economic shock and by early 2009 oil was trading at around $35, down more than $100 a barrel from its high less than a year before.
Now that we're in another down cycle, some analysts are saying it's time to swoop in and buy energy stocks at beaten-down prices. Not so fast. Oil prices could (and probably will) go lower, dragging energy stocks down even more in the process. There will be a time to buy but we're probably not there yet.
My advice at this point is to stand back and watch. Retain existing positions in quality energy companies but don't make new commitments. Keep a close eye on oil prices. Don't expect to buy right at the bottom but when the price rebounds by 10 per cent from the 52-week low it will be time to start adding to your energy positions.
Of course, I'll keep watch on developments over the coming months and keep you informed. Oil is going to be one of the top financial stories of 2015.