In a widely anticipated move, the members of OPEC and their nonmember partners agreed to increase output by 1 million barrels a day (BPD) starting in July, though the actual increase will be much smaller than the headline number. This accord is a step back from the initial plan to hold back about 1.8 million BPD through the end of the year to hasten the rebalance between supply and demand. That strategy has worked out much better than expected due to unexpected supply issues both within OPEC and in the U.S.
What might come as a surprise to some is that oil prices turned sharply higher on the news. The U.S. oil benchmark, West Texas Intermediate, was up more than 3.5% in early trading to nearly $68 per barrel, while the global benchmark, Brent, was up about 3% to more than $75 per barrel. Driving these gains is the market's relief that OPEC's agreement seems to have addressed the need for more oil without going too far. Because of that, oil stocks could continue thriving in the second half of this year.
Details on the deal
While OPEC has agreed to boost output by 1 million BPD, the actual increase will likely be between 600,000 to 800,000 BPD, according to analysts, as most members can't just flip the switch on pumps and quickly boost output. That's a much more modest hike than some initially feared.
Driving OPEC's decision to boost production are supply problems in Venezuela and Libya. Output in Venezuela has fallen off a cliff in recent months due to the country's economic turmoil. Production in Libya has also been under pressure due to political unrest. Nigeria, too, has experienced some production problems, and Iran's output might fall due to new U.S. sanctions. Because of those issues, OPEC's actual supplies have come in well below forecast this year, which is why crude prices have risen so sharply.
On top of those problems within OPEC, pipeline constraints in Western Texas are starting to impact the ability of producers to continue growing production in the region. Drillers have left a record number of wells unfinished, or slowed their drilling pace. Meanwhile, it's growing increasingly likely that some producers might need to shut down a portion of their oil pumps until new pipelines come on line late next year.
Those factors had the potential to cause oil supply to be as much as 1.8 million BPD below demand in the second half of this year, which could have driven oil prices even higher. That scenario could have started impacting the global economy, and in turn oil demand would have eroded. However, with OPEC bringing some oil pumps back on line, this shortfall won't be quite as concerning, which should keep oil prices from rising too high.
Why this is a boon for oil stocks
OPEC's decision to moderately boost production should keep oil prices around their current level, which is ideal for most oil producers. Many have reset their operations to run on $50 oil, setting them up to generate a significant windfall of cash if oil stays between $65 and $75 a barrel.
Leading shale driller EOG Resources (NYSE:EOG) built its business to prosper at $50 a barrel. At that price point, the company can generate enough cash to grow oil production by 16% to 20% this year. And at $60 oil, EOG Resources could produce $1.5 billion in free cash, with even more at current prices. EOG plans to use its incoming windfall to pay off debt and boost its dividend, both of which should grow shareholder value.
Marathon Oil (NYSE:MRO) is another oil producer built for $50 oil. At that level, Marathon can generate enough cash to grow its U.S. oil production 25% to 30% this year, while at $60 oil, the company can produce $500 million in free cash -- and even more at current prices. Marathon Oil has a range of options for that money, including buying back shares, boosting the dividend, paying off debt, or acquiring more drillable land.
All signs point to 2018 being a great year for oil stocks
OPEC struck a happy balance with its agreement to boost supply: It should help stave off a spike later this year without flooding the market with too much new oil in the short term. As a result, oil prices appear poised to remain around the current level, which is well above the price most oil producers anticipated this year. That should enable them to continue cashing in from the higher pricing, which could provide the fuel to push their stocks even higher later this year.