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As Oil Prices Climb, Here’s How to Play the Rebound in Energy

by | published February 13th, 2015

As I write this, crude oil prices continue to advance. Brent is over $61 a barrel, while West Texas Intermediate (WTI) is pushing $53.

Both are higher than at any time since before Christmas.

Absent any major geopolitical tension, beyond the levels we’re already seeing, oil prices should begin to level off.

And while oil is not going to surge in the short-term, a floor has emerged that is going to hand us some fantastic new opportunities.

Oil won’t have to hit triple digits for them to pay off either, provided certain factors continue to fall into place.

But in today’s world it’s not all about oil, not by a long shot. The biggest gains are more likely to be found elsewhere in the sector.

So in today’s issue, I want to sketch out my strategies to profit off the rebound in energy…

Oil Prices: Unconventional Production is Still the Wildcard

This strategy has two central considerations. The first involves what’s happening with oil. The second outlines the broader energy investment opportunities this changing market will provide.

Today, I’ll discuss oil. Next week, I’ll talk about a range of opportunities outside of crude.

Even with higher prices, it’s important to keep in mind that crude is still subject to several major considerations. Initially, and still most importantly, are the ongoing supply side issues. The oil “glut” is the biggest reason oil prices fell over the last quarter of 2014.

That’s because there was a much bigger increase in U.S.-based shale and tight oil production than originally estimated. What’s more, on a longer-term basis, these unconventional reserves are going to develop into a global supply issue, since some 86% of the recoverable unconventional oil reserves are actually located someplace other than North America.

Now admittedly, these global reserves will take longer to develop, since they require considerable capital expenditures to create a full infrastructure network and service support system. But this is a trend that will unfold by the end of this decade and continue at least until 2035.

However, unlike previous downturns in oil prices, the demand side is holding up well.

Despite the overblown alarm spouted by the so-called pundits, 2014 recorded the highest daily global demand for oil on record, and it’s expected to grow by about 1.6% this year.

In fact, both OPEC and the International Energy Agency have raised their demand estimates again, while lowering non-OPEC conventional production expectation. U.S. shale and tight oil remains the wildcard, and it will probably take two quarters to determine the impact production cuts will have.

The difference this time is that, despite global daily demand being within 2 million barrels of the available export supply reserves (virtually all Saudi), we now know there is considerable excess capacity available on the unconventional side.

As expanded U.S. crude oil exports are approved, that capacity will have a more worldwide effect. All that’s needed on this front is for Congress to change the statute. That’s very likely now.

It’s as Simple as Supply and Demand

The key here remains a balance between supply and demand. That also means a new balance between OPEC and non-OPEC production.

OPEC continues to control 40% of the world’s production. But that doesn’t buy what it used to. As I and several other analysts have noted, the traditional “call on OPEC,” the monthly draw on extractions by which the market used to be balanced, has quickly given way to the “call on shale.”

The U.S. ultimately determines the supply-demand equation. But remember: While the excess supply is now American, the demand is still determined by regions elsewhere in the world.

Of course, oil prices will still have much to say about the overall strength of the energy sector. But it’s not nearly as important as it was just six months ago. There are different energy expectations now in play that will determine where we invest.

In the current pricing spread, oversold oil and natural gas stocks offer some nice upside. In fact, by the second quarter of this year, I expect WTI to trade between $60 and $65 a barrel, and I expect Brent to see a range between $68 and $72 a barrel. By the end of this year, WTI could trade in the low $80 range.

Yet, as I told Energy Advantage subscribers earlier today, this will only happen if certain factors fall into place.

The most important is lower production in the face of continuing supply side surpluses. This will depend on the ability of U.S. operating companies to limit new projects of a certain type.

Not all new production will be discouraged. The extension of vertical, shallow pattern drilling emphasizing known basins and low-cost operations will actually be encouraged in this kind of climate. The reductions are going to come from the larger, deeper, horizontal/fractured, and much more expensive projects.

But this rebalancing will take some time and we will continue to see excess production until it kicks in.

Of course, several pundits continue to insist that declining rig counts aren’t an indication of a cut in production, since nearly the same volumes continue to be extracted from existing projects.

There is some truth to this. Falling rig counts simply point toward a readjustment of capital expenditures, but say nothing directly about the wells already finished.

After all, since 80% of the costs of these project is front-loaded, it makes sense to continue production at existing wells.

However, what this analysis misses is the declining production curve at these wells. All wells reach maximum production rather quickly. It then becomes a consideration of what secondary recovery techniques (water flooding, natural gas reinjection, chemical additives) are added to reduce the rate of decline.

When shale and tight oil/gas production is considered, that decline curve happens even faster. The majority of the extraction from these wells takes place over the first 18 months of operations.

This is the important point to remember. Given the age of currently producing wells, the aggregate declines won’t begin to show up until this summer. The market understands this and is already building it into futures contract pricing.

Where We Go From Here

Now that doesn’t mean there will be a race in the other direction. But it does mean the supply side excess will begin to level off. Given that global demand is moving up again, the prospect emerges for a better pricing picture.

But there is not going to be a “rising tide that lifts all boats” in this scenario.

The location of the drilling, increasing efficiency, the ability to expand known reservoir development with step-out wells, access to existing infrastructure, and direct tie-ins to end users (read: refineries) will be important.

Then there are the financial pressures. Some companies will require either mergers or straight acquisition to continue operations. There will be more consolidation, and the sector promises to look different (and leaner) in only a few months.

In addition, we will also see a restructuring of assets throughout the upstream (production) to midstream (transport and soon export) to downstream (refining and distribution) process.

All of these will hand us some very nice investment opportunities.

But again, this story is much bigger than oil. And in the next issue, I’ll discuss the range of opportunities outside the world of crude.

Please Note: Kent cannot respond to your comments and questions directly. But he can address them in future alerts... so keep an eye on your inbox. If you have a question about your subscription, please email us directly at customerservice@oilandenergyinvestor.com

  1. Bob
    February 13th, 2015 at 18:57 | #1

    Hi Kent:

    The WSJ reports today on speculation that XON could be in line to acquire BP. Any thoughts?

  2. Norman Harper
    February 13th, 2015 at 20:55 | #2

    It seems to me that Clean Energy Fuels(CLNE) will be in a good position to compete with oil, particular Diesel, considering they have 500 plus refueling stations in place now. Granted the mpg is slightly less than Diesel but the Green aspect and lower cost will offset that. Their recent alignment with Agility Fuel Systems can only be a plus. Granted it will take time, but they have fueling stations already in place, a significant number here in Pennsylvania where I live.
    My Background: I grew up in the Oil Industry, working in my Dad’s service station, my grandfather was a wild catter in Kansas (for gas), two years of Geology before USNA, followed by Diesel and Nuke Submarine duty. Always felt the Navy made a mistake in following Rickover instead of going for Fuel Cells (Allis Chambers had a Fuel Cell Tractor in operation in the 50s). Had we put the $ into Fuel Cells what we put into Nuclear Power we not only would have an all Fuel Cell Navy, all of our vehicles would be Fuel Cell powered. By the way our Submarines obtained our Oxygen from sea water and dumped the Hydrogen overboard. Norm Harper, Captain, USN Ret

  3. William Schlottermiller
    February 13th, 2015 at 22:17 | #3

    Dear Dr. Moors,
    Please accept my humble gratitude for your invaluable insights into the realm of geopolitics,macroeconomics and how numerous complex factors influence your research and analysis regarding the fascinating and ever changing energy resource investing markets.If one were to conclude that the U.S.A. and other nations were indeed in the colder war with Russia,would you please do an article specifically relating to the possibility of a reverse sanction against us pertaining to the curtailment of uranium exports and if this could be a profitable scenario for those astute investors looking at the big picture. Since Putin is basically in an economic war with the U.S.A.,why would he want to supply us with the resource essential to power our domestic nuclear power plants and perhaps military applications as well? Assuming current stockpiles are decreasing due in part to the price and reduced mining endeavors,I see the potential for enormous gains in this sector perhaps this year and if one were to invest in the right miners,a windfall of profit could be a life saver. Your addressing this topic besides oil would be graciously appreciated, Respectfully yours,William S.

  4. schippe1
    February 14th, 2015 at 04:43 | #4

    Looks like the TMS will be going no where for the next ten years.

  5. SS
    February 14th, 2015 at 18:13 | #5

    I don’t think the supply of Shale oil will drop much. It will need to be soake up by demand. Most oil companies are forecasting at least steady production levels. With most saying they will still increase output. In Canada alone we are set to bring on 400-500k BPD this year of new Oilsands production. As we saw with Nat Gas a couple years ago. Falling rig counts don’t mean anything with respect to production growth. Cost savings and higher productivity from each rig by increased efficiency and Pad drilling can no doubt increase production. If oil prices stabilize in the 50-65 range you will see companies start to drill in the sweet spots. These companies are driven by investors and management who’s salaries and bonuses depend on production growth and cash flow. It will be a long slow crawl out from this decline. With Storage filling up fast, there could be a big drop coming as there will be no place to put all the Oil.

  6. Darrell Mordente
    February 19th, 2015 at 17:40 | #6

    Ken,

    Can you give us some actionable investment advice. What companies should we invest in now to catch the rise in oil? And will refineries, which have risen so much, go down with rising oil costs?

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