What's Next For Big Oil After OPEC Production Cut?

In a bold but not unexpected move, the Organization of Petroleum Exporting Countries (or OPEC) cartel agreed on Wednesday to reduce production starting next month. Seen as a desperate bid to put a floor on falling oil prices, the group – led by Saudi Arabia – promised to take 1.2 million barrels a day out of the market.

OPEC’s First Output Cut in 8 Years

OPEC's decision to cut oil production was not totally surprising though the magnitude of reduction were deeper than many analysts had expected. The move aims to trim output to 32.5 million barrels per day -- at the low end of a preliminary agreement struck in Algiers in Sep.

Crude prices, which reached $110 per barrel in mid-2014, fell to a 12-year low of $26.21 in Feb on a supply glut amid slowing demand. In particular, the oil rout alarmed many of the countries whose economies depend on the commodity’s exports.

A sop to populous big-spending oil producers such as Venezuela and Iran, the cartel’s cutbacks was a mild loss for Saudi Arabia that has been adamant about its continuing strategy to preserve market by pumping oil almost flat-out rather than trying to prop up prices by modifying production limits.

Riyadh was forced to soften its stand after it became clear that the kingdom was getting clobbered by its own policies. As a result, the world’s largest crude exporter gave its seal of approval on the cartel’s production cut decision – the first such attempt since 2008. What’s more, Saudi Arabia will bear the lion’s share of the production cuts to accommodate arch rivals Iran’s demands.

It will trim volumes by nearly a half a million barrels per day, while allowing arch-rival Iran to boost production slightly. Another fast-growing producer Iraq surprised pundits by pledging to curtail output by 0.2 million barrels per day.

Gets Russia to Comply

Russia, which is not part of OPEC, will also join output cuts for the first time in 15 years. The biggest supplier outside the bloc relented from its longstanding position of only freezing production and agreed to cut 300,000 barrels from its record high output of more than 10 million barrels a day.

Oil Prices & Stocks Climb

Oil prices jumped Wednesday to their highest point since Oct 27 as investors were impressed by a decision from the world's largest oil cartel to slash production targets. U.S. crude for Jan delivery settled up $4.21 (or 9.3%) to $49.44 a barrel in New York.

Expectedly, the early reaction in energy stocks has been positive. The S&P 500 energy sector index on Wednesday soared by as much as 4.8% -- its largest gain in 15 months.

Independent oil explorers and producers, whose revenues are directly associated with crude price, were among the best performing stocks. Marathon Oil Corp. (NYSE:MRO) was up 20.8% on the day, Newfield Exploration Co. (NYSE:NFX) – a Zacks Rank #2 (Buy) company – jumped 15.7% and shale specialist EOG Resources Inc. (NYSE:EOG) soared 10.9%. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here .

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Oils-Energy Sector Price Index

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Effect on Big Oil

While most of the gains were in the small/mid cap or exploration/services markets, the large cap oil space fared well too. In fact, supermajors ExxonMobil Corp. (NYSE:XOM) , Chevron Corp. (NYSE:CVX) , Royal Dutch Shell (LON:RDSa) plc RDS.A and BP plc (LON:BP) (NYSE:BP) were among the biggest gainers among blue-chip stocks, all moving up 2% or more -- a significant rise considering their status as ‘traditionally defensive stocks.’ Chevron shares even hit a new 52-week high.

The Saudi-brokered oil production deal is being hailed as a positive outcome for the overall oil market especially when oilfield services cost remains low. It is expected to bring much needed stability to the market with prices set to improve steadily. Multinational oil enterprises (like ExxonMobil, Chevron etc.), on the back of greater certainty, will now be able to revive spending on drilling activities. This is set to drive their upstream segment’s revenues, earnings and cash flow.

Moreover, large integrated companies (or ‘Big Oil’) – unlike their small or medium-sized producers – are not known to hedge a major share of their future production. So, they are more likely to benefit from OPEC-driven higher spot prices.

On the flip side, a sustained crude rally will render their refining unit unprofitable. As it is, there are signs of weakness in the downstream business, suggesting that the unit – which saved the supermajors when crude prices plunged – could now be a drag. The most recent quarter saw the integrated behemoths’ downstream segment income erode on fuel oversupply and weak demand.

With refineries being buyers of crude, an increase in oil prices can squeeze their profitability. As a result, with the commodity’s price expected to increase in the near-term, we expect Big Oil’s margins to be negatively impacted due to a rise in the cost of oil they buy to make gas, jet fuel and other refined products.

Finally, the stocks mentioned above – ExxonMobil, Chevron, Royal Dutch Shell and BP – are generally aligned in tandem with long-term oil prices, rendering short-term fluctuations in the spot market as non-events.

On balance though, we see more upside potential than downside risk from current levels.

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Written By: Zacks Investment Research