What happened
Oil prices surged more than 5% on the first trading day of 2021. As a result, WTI, the U.S. oil price benchmark, topped $50 a barrel for the first time since last February. Fueling the rally was an unexpected move by Saudi Arabia, which said it would cut 1 million barrels per day (BPD) from its production starting in February.
The rally in oil prices powered an even bigger rise in most oil stocks. Several had jumped more than 10% by 3 p.m. EST today, including Core Laboratories (CLB +0.00%), Centennial Resource Development (CDEV 0.70%), Marathon Oil (MRO +0.00%), Diamondback Energy (FANG 0.70%), and EOG Resources (EOG 1.27%).
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So what
The oil market has been keeping a close eye on OPEC, given that it controls much of the global supply. That's why Saudi Arabia's move is a pleasant surprise since it's acting alone after the rest of OPEC agreed to hold its production steady next month before raising it in March.
Meanwhile, Russia and Kazakhstan (nonmembers working with OPEC to support the oil market) each want to increase their output by 500,000 BPD starting next month. As a result of Saudi Arabia's decision, the oil market won't add any new supply next month, which will enable the economy to burn off more of the excess inventory as it slowly recovers from the COVID-19 outbreak.
With limited new supply hitting the oil market next month, it should help keep the pressure off prices. That's excellent news for oil producers since higher prices mean they'll generate more cash flow.
For low-cost producers like Marathon Oil, Diamondback Energy, and EOG Resources, $50 oil is a considerable tailwind because they'll be able to produce significant free cash flow. That will give them the funds to repay debt, fund share repurchases, and maintain their dividends.
For example, Marathon noted that in a $45-a-barrel environment or better, it intends to allocate more than 30% of its cash flow toward balance sheet enhancement and returning capital to shareholders, which could be share repurchases or a variable dividend.
Meanwhile, higher oil prices are a lifeline to financially troubled oil producers like Centennial Resource Development. The company ended the third quarter with just $314.1 million of liquidity after its banks had previously cut the borrowing base on its credit facility from $1.2 billion to $700 million. Because of that, the company had spent most of last year trying to shore up its balance sheet. That will be easier to do at higher oil prices since Centennial should generate more free cash flow to use toward debt reduction.
Finally, an oil field services company like Core Laboratories should also benefit from a higher price for oil. While it won't directly impact its cash flow, it should improve the volume of work Core does for its oil company customers this year. That should eventually boost its bottom line.
Now what
Saudi Arabia is making sure that the oil market has all the support it needs by single-handedly agreeing to hold back some of its production next month. That should keep the pressure off prices, which would benefit oil stocks.
However, the oil market remains in a fragile state since it's relying on the assistance of OPEC and others to keep it from drowning in too much crude. Because of that, if Saudi Arabia or other producers remove their support too soon, prices could tumble, which would likely take oil stocks down with them.
