The Secret to Predicting Oil Prices – and Cutting Through the “Expert” Hype
If you turn on the TV today, you’re likely to see only two kinds of oil price “predictions.”
One is the wishful “thinking” of those who claim a further spike in oil prices up to $60 a barrel is coming.
The other is the baseless (and self-serving) “warnings” of another dive to $25 a barrel.
The reality of the oil market lies in the middle – a narrow trading pattern in the $40s, with the floor rising slightly through the end of June.
This price stability is enough to provide some very nice investment opportunities moving forward. The days when oil has to be at $80 for average individual investors to make money are long gone.
So let’s pull back from the smoke and mirrors offered up by the so-called “experts,” and look at what’s really happening.
To form realistic expectations about oil prices, there are four factors you need to know.
Geopolitical Risk is Once Again Key
Now, bear in mind that these four factors will dictate where oil goes as long as geopolitical factors don’t distort the market.
Of course, the outliers of global events are themselves becoming an ongoing element in the determination of what is likely to happen in the market. For example, they are already a mainstay in my (or anyone else’s) risk assessment matrix on oil.
Nonetheless, there remains a proper foundation for forecasting price – and it’s not a crapshoot of hype, or the spreading of implosion fears.
The former serves the interests of cash-strapped private producers, often one step ahead of the sheriff (or the bank holding their unsustainable debt load). The latter comes from short artists who often are doing nothing other than playing upon investor angst to scream that the sky is falling.
Both amount to unrealistic expectations – either that the market will snap back quickly (at least in terms of price) or that a quick return can be gained from convincing folks like you that this is the end of traditional oil profits.
Instead, here’s what’s really happening…
Recent Supply Disruptions are Temporary
Crude oil supply continues to outstrip demand, resulting in the single biggest restraint to rising prices. Now, the problem is not that oil demand is falling. Internationally, it’s rising, and this year will end with the highest daily demand levels on record.
Rather, the problem comes from excess production and, more to the point, substantial excess extractable reserves.
I have talked about this on several occasions here in Oil & Energy Investor. In short, the issue is not so much the surplus of crude already in the market. Instead, prices are being pushed down because traders know that there are huge amounts of additional oil volume that could be easily extracted.
Meanwhile, the current wildfires in the Athabasca basin and elsewhere in Western Canada, combined with the continuing civil strife in Libya and the rising political tensions in Nigeria, have cut out some 2.5 million barrels of daily global oil production.
That amounts to about twice the normal surplus.
Now, each of these events is regarded as either a temporary situation (much like the strike by oil workers in Kuwait earlier this year) or a factor that will be easily offset by increased production elsewhere.
Saudi Arabia, for example, announced today that it intends to increase its oil production “to meet demand.” More properly, of course, this is to meet demand not met by short-term constrictions from other sources.
U.S. production for the week ending last Friday also seems to be lower than anticipated. That will also prevent any appreciable drop in prices. Yet until American extraction makes its way into genuine international trade (rather than merely influencing supply by impacting imports into the U.S. alone), the dynamics are more influenced by what is occurring abroad.
I will have more to say about what this actually means for longer-term views on prices in about a month. You see, something huge is developing… something that will have the effect of stabilizing the market even more.
But for now, here are the four factors you need to know to form realistic expectations of where oil prices are going…
Oil Factor #1
U.S. Oil Production is Peaking
First, despite technical improvements improving wellhead efficiency by at least 17%, U.S. production from the last major wave of more expensive shale and tight oil wells has peaked – or will soon begin to do so.
This is because these wells produce the majority of their oil in the first 18 months of operation, on average.
In normal times, operators would initiate secondary and enhanced oil recovery (water flooding, natural gas injections, chemical applications, and the like) and rework or refrack the well to push back the extraction decline. But with oil prices below $45 a barrel, it’s just not cost-effective.
That means existing DUCs (drilled but uncompleted wells) will be finished in order to replace existing wells, not to increase overall production.
Oil Factor #2
The Energy Debt Crisis is Reaching Catastrophic Levels
Second, the oil patch debt crisis is quickly getting worse for a range of private and public oil companies. Most of these companies simply cannot roll over their existing high-risk (i.e., “junk”) bonds because their effective annualized interest rate is approaching 21%.
This has dramatically curtailed an already significant reduction in future capital commitments for both new and existing projects.
The effect will be a decline in the total number of players in the U.S. oil and gas sector – whether via bankruptcy, mergers, or acquisitions by survivors.
It remains in the survivors’ interests to balance production rather than turn on the taps.
Oil Factor #3
The U.S. is not Alone – UK and Latin American Production is Also Falling
Third, other non-OPEC producers also face serious problems. In the North Sea, despite UK budget proposals that effectively eliminate major taxation on British companies continuing to drill offshore, a declining basin has made increasing production too expensive.
Brazil and Mexico are having their own problems, stemming from either internal politics, scandals, or limitations on available capital.
Now, a sustainable oil price north of $60 would begin changing this picture quickly, while one above $70 would put most projects back in play.
But that’s not going to happen anytime soon.
Now, each of these three considerations contribute to a floor for oil prices. But this next one does not, as a major geopolitical concern again emerges…
Oil Factor #4
The Iran-Saudi Conflict is Intensifying
I have noted previously that the Iranian attempt to reach (and continue production at) levels the country had prior to Western sanctions is running into huge field problems, lack of sufficient investment, and shortcomings in technical expertise. Meanwhile, the lofty ambitions across the border in Iraq to increase production are falling victim to rising sectarian political disagreements and an increase in violence.
You might think that both of those would depress oil production, thus supporting prices. Unfortunately, there is another matter emerging.
There are now clear signs that Saudi oil policy, now under the firm control of rising power behind the throne Deputy Crown Prince Mohammad bin Salman Al Saud, will be used as a weapon against Iran.
This is the latest development in an ongoing Saudi-Iranian (or Sunni-Shiite) conflict over ascendancy in the region. Crown Prince Mohammad is even more anti-Iranian than is his father King Salman.
He is also the Saudi Defense Minister, and a big supporter of Saudi Arabia’s fight against Iran-sponsored groups in neighboring Yemen.
It will be interesting to see how this plays out in the run-up to the next oil summit on a possible production freeze – set for Moscow next month. At present, Riyadh will use any pretense to guarantee that non-Iranian exports control the global market.
Meanwhile, Saudi Arabia is pressuring OPEC to maintain high production levels (and is increasing its own oil extraction), in an attempt to crowd Iran out. This will put a cap on how fast oil prices increase worldwide.
Remember, we don’t need high oil prices to make money in this market. All we need is a narrow trading band amidst some stability in pricing expectations.
But the unreasonable expectations of both long and short “dream” traders won’t move this market. Reality will.
[Editor’s Note: Kent’s Energy Inner Circle readers are already perfectly positioned to profit from oil’s rising price floor. To see how you can join them, click here. After seven years, the final piece of the puzzle has finally fallen into place…]