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