Oil producers have taken a savage beating on the ASX over the past two months, with the international price for their product still falling to slip under US$85 per barrel – the lowest price since 2010 – in the past few days.
Beach Energy Ltd (ASX: BPT) and Drillsearch Energy Limited (ASX: DLS) are trading for less than they were a year ago, with Beach down 6% and Drillsearch down 7.3% over the past 52 weeks.
Woodside Petroleum Limited (ASX: WPL) is up just 2.5% for the year at $39, having fallen drastically from recent highs of $44 in late August.
In fact the rout is pretty much universal across ASX oil companies, with Santos Ltd (ASX: STO) down 14% for the year, Oil Search Limited (ASX: OSH) down 1.5%, and Cooper Energy Ltd. (ASX: COE) up just 5%, but down 30% from July highs.
Despite the nervousness in the sector, I believe that the market has got it wrong and that many of these shares are an outstanding buy at current prices.
The value of oil is traditionally supported by what is essentially cartel activity among the Organisation of Petroleum Exporting Nations (OPEC), a collection of major oil producers who often adjust their output to affect prices as desired.
OPEC's 12 members produce a little over a third of the world's daily oil production (33 million barrels per day) which offers the group considerable pricing power.
Recent falls in price are due to a surplus of supply and investor fears, with OPEC members appearing to follow Saudi Arabia's lead in stating there is no need to reduce supply.
Factor in booming US shale oil production and general uncertainty in the market and it's no surprise that the price of oil has dropped like a rock.
It's a total overreaction.
Driven by fear and the rain dance that is media reporting, investors have run for the hills without checking the facts.
A read of the International Energy Agency oil market forecasts for 2014 (released Tuesday) show that total global supply is currently 93.8 million barrels a day (mb/d), compared to demand of 92.4 mb/d.
That's a 1.5% surplus.
It's barely significant in the grand scheme of things, yet it's driven a 26% decline in oil prices since June; ASX oil shares have fallen further.
So you tell me, are sound economics at work, or do investors have a great opportunity to stock up on quality companies?
There are a couple of things to bear in mind before making an investment:
Firstly, the world's most experienced and capable oil producing nations say there is no need to reduce production.
They're capitalist, naturally self-interested, and given that oil is one of the biggest sources of prosperity for OPEC nations, falling oil prices hurt them a lot more than you or I.
They have a lot of skin in the game. So if they say there's nothing to worry about, I'm inclined to believe that's the case.
Second, falling oil prices damage revenue a lot more than higher production can replace.
As an example, 33 mb/d sold for US$85 each earns $2,805 million a day.
Given the current 1.5% production surplus, let's say we assume that a 3% reduction in output would bring oil back to August prices of around $100 a barrel.
OPEC nations would then produce 32.01 mb/d for a total of $3,201 million per day.
Thus the Organization has a significant incentive to drop production to maintain prices, and I believe that should today's oil prices become a concern for OPEC, investors can rely on reduced output to bolster prices.
There are a number of factors supporting the global outlook for oil, and while the situation is more complicated than my simple example, I believe ASX oil producers are on sale at very compelling prices and I am in the process of shopping for some.
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