As the volatility in oil prices has proven over the past several weeks, there is no roadmap for this new environment.
While traditional notions of supply and demand drive the knee-jerk reactions to gyrating prices, the truth is nobody has a clear read on where the market is going in the very near-term.
Over that time frame, the prospects are good for a move up…
Oil Prices: Forget About the Talking Heads on TV
That’s true despite the fact that oil prices are dropping again into a range that should see a near-term floor near $42 a barrel for West Texas Intermediate in New York and $52 a barrel for Brent in London.
Despite a weekly decline of almost 5.2% in New York and 4.4% in London through the close yesterday, there is actually little pressure for a protracted downward spiral in oil prices.
This is where it is important to distinguish what is actually supportable in this market versus the doom-and-gloom story touted by the talking heads on TV.
At the moment, the biggest concern affecting oil prices are the high surplus supply levels. This is especially true in the U.S., but it is also emerging elsewhere in the world.
In fact, in its just released monthly report, the International Energy Agency (IEA) is now projecting a more prolonged oil glut than initially forecast. In particular, U.S. oil production jumped 115,000 barrels a day in February, which according to the report “would lead to renewed price weakness.”
However, that’s based on two factors that will simply not continue: production levels staying where they are, and a lack of capacity to store the excess production.
Now don’t get me wrong. I am not suggesting that we are moving into an environment that will send us back to $90 a barrel by the end of the summer.
But I do believe oil prices will climb to about $58 a barrel in New York and $65 a barrel in London by late August, assuming there are no new geopolitical “wild cards” that cause prices to spike much higher.
And remember, what we’ve come to recognize as high oil prices are no longer necessary to generate some nice returns on retail energy investments.
The truth is the oil/natural gas sector is entering a very competitive and profitable environment. As the mergers and acquisitions (M&A) cycle heats up throughout the year, that competition will provide a number of fantastic new opportunities, along with some excellent existing niche plays.
As the M&A cycle kicks in, smaller highly-leveraged companies will become the targets of other American operating companies seeking to add to their book reserves by picking up assets at a market discount.
The combination of a potentially massive global supply glut coupled with energetic M&A activity is bringing us into virgin territory.
Estimating the “trigger price” of oil that will cause a meaningful reduction in production while at the same time finding and valuing acquisition targets is simply unique in my 40+ years in the business.
Even so, the latest IEA projections and some of the amateur reads on what it says misses the obvious: These projections are based on extrapolating today’s production rates far into the future.
What they don’t account for is the accelerating industry pullback that has already begun.
Where the IEA Report Gets It Wrong
You see, the massive buildup of production in the U.S. oil patch has been fueled by high-risk debt and unexpectedly excessive extraction rates. So while the rig count continues to fall and forward capital expenditure plans across the board continue to be slashed, a significant amount of production still remains from existing American wells.
It is here that the excess production is prompting the some of the biggest misgivings. It’s true, storage capacity is disappearing. However, producers are faced with quite a different picture.
As we have noted before, well over 80% of the expenses in an oil project are frontloaded. That means the vast majority of the capital is invested before anything comes out of the ground. So it’s in the interest of the operator to continue to pump – even if the wellhead price is falling. Even at lower prices, the longer the well produces, the more after-expense revenue is realized.
There are two important factors to remember here, though, in terms of the projected supply glut.
First, the primary production curve of an unconventional (shale and tight oil) well is about 18 months on average. Given this fact, along with the current age of the existing wells, it only follows that production will decline by mid-summer. Combined with the drastic cut in future drilling plans, that means the glut will begin to eventually draw down.
Second, the IEA’s 2016 projection is predicated upon a drawdown in stored production combined – not with a declining forward production picture – but continued existing volume.
That’s just not the picture that is emerging.
That finally brings me to another observation about price. Traders who make their living by betting on the future price of oil have introduced an interesting hedging strategy.
While some new shorts are emerging (indicating a near term downward pressure in prices), the broader market is still moving into long positions, a calculation by traders that prices will be moving up. It’s supported by oil futures contracts that are now in a state of “contango.”
Contango is when the futures contract price is higher than the expected spot price moving forward into the year. It points to higher oil prices.
The bottom line: keep your power dry. As oil prices stabilize and begin to move higher, there will be plenty of nice moves headed your way.
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