Why The Oil Market Isn't Making Sense To Many Investors

|
Includes: EOG
by: Gary Bourgeault

Summary

The market doesn't understand the full impact of U.S. shale.

Are demand and inventory really 'unexpected' surprises?

Sustainability has little to do with this market.

(click to enlarge) source: GSTT Click to enlarge

Listening to many financial outlets, along with responses from various analysts and investors, there is not doubt there is a lot of uncertainty and confusion surrounding the oil market at this time.

This is why we continually hear terms like "unexpected," when a outcome doesn't match the presumed outlook. The reason why that is happening a lot is the majority no longer no how to read oil, and the key reason is they don't know how to assimilate shale oil into their models, which in the not-too-distant past, wasn't part of the equation.

Even management of major oil companies make the assertion the price of oil must rise because it's not sustainable at this level. The question has to then be asked as to not sustainable to whom.

U.S. demand and inventory has been another surprise to those watching the oil market, as it seems every week the projection is for inventory to drop, while most weeks it "surprises" the market by not dropping.

We'll get into a few of the variables to help clarify what we're to make of all of this.

U.S. shale industry

Until fairly recently, the market hasn't had to include U.S. shale production on the competitive side. Those days are long gone, and this is just the early stages of the shale revolution, which will spread across the world over the next decade.

At this time there are an estimated 419 billion barrels of recoverable shale oil in the world, and that number will rise once there is more exploration, as Argentina has proven.

What is unique about shale besides the formations, is there are more ways companies can extract oil from them than other types of deposits.

For example, companies can drill but not complete wells (DUCs), which allows them to invest on the front end while waiting for the most opportune and profitable time to bring them into production.

They have also recently figured out how to extract oil in a very targeted way, which allows them to tap into the best deposits, which lowers production costs.

What this means, when taken together, is some of the tight formations already under production can bring a lot of oil to market at a decent profit, while DUC wells are waiting for the price of oil to move up - probably above the $40 per barrel mark. EOG Resources (NYSE:EOG) has stated it can make money at $40 per barrel.

How that has an impact on the oil market, and what has changed the game for a long time, is shale oil now has more of an impact on the mid and upper price range of the market, while OPEC retains control of the lower end of the market by keeping production levels high.

U.S. demand and inventory

One of the variables we have yet to figure out is how all of this will play out in regard to supply and demand in the U.S., and of course the resultant inventory levels.

For now tight oil seems to be the main catalysts for what is identified as 'surprise' inventory levels to the upside. It appears what is happening is companies are in the sweet spot on many of these wells, and they keep on pumping more than the market needs domestically. It's also why the drop in rigs hasn't had much of an impact on the market.

I take rig counts with a grain of salt now. For now it really doesn't matter what rigs are taken out of production, because DUC wells have changed the meaning of rig counts, because they can very quickly be brought into service.

As for inventory and demand, shutting down rigs doesn't have an impact because of the tight oil already mentioned, and the ability for companies to zero in on the best spots to produce oil in their existing, operational wells. This is unique to shale in regard to how localized it can get; meaning they can target very small areas of the deposits and formations.

These are the things investors need to consider when news reports on lower rig counts are considered a prelude to declining inventory.

The sustainability factor

On the so-called sustainability of the industry under these price levels, I largely ignore that as well. Why? Making an assertion the industry can't sustainably go forward at these prices, is proving to be untrue. I believe these sentiments are echoed because the industry obviously wants the price of oil to go up, and saying it has to is a way of trying to generate support for the price in order to become a type of self-fulfilling prophecy.

For a market that allegedly can't be sustainable at the current price range of oil, they're sure continuing to produce. Always look at the actual actions of the industry and companies, and not what is being asserted.

I'm not saying the price of oil won't eventually rise, because over time it will. What I am saying is whether or not it's sustainable or not isn't what will drive the market.

Think of the iron ore sector. Large companies keep mining it even as the market remains subdued. One reason is they are eyeing some very lucrative properties they'll grab at bargain prices once smaller competitors can no longer compete at that price level. I see the same thing, in many cases, happening in the oil industry.

There are a lot of oil assets that will be offered for sale as smaller companies struggle to make it. That's especially true in U.S. shale.

For that reason alone, sustainability has little to do with where the price of oil will go in the near term. It's also why larger competitors don't mind sitting on the sidelines and taking some pain. Once the smoke clears they should be much stronger in the years ahead.

Conclusion

Most of those watching the oil market believe it actually wants there to be a rebalancing. I disagree with that assessment in the shorter term, by which I mean the next year or two.

There is still a lot of adjustments and pain to go through in the U.S. shale industry in particular before any of this settles down. Even there I don't anticipate it being as deep as many believe, because it has become extremely efficient and resilient in the fact of extraordinary attempts to slow it down (it's impossible to crush it).

What investors need to understand is shale oil is not only important because of it bringing supply to the market at levels never experienced before, it's important because of how it produces, as mentioned earlier in the article.

In the past oil competitors knew exactly what their competitors were doing and how much oil could be brought to market. That is no longer the case now that shale oil is part of the competitive landscape.

When analyzing oil, remember that rig counts no longer mean what they did in the past, and even if they're brought down to very low levels, that could easily change to the upside in a month with the hundreds of DUC wells waiting to be brought into production.

Also a new factor is DUC wells, in essence, are a new form of oil storage. Oil from them doesn't need to be extracted and stored somewhere, it can remain in the ground until the right market conditions emerge. This is part of the inventory equation that wasn't there in the past either.

This should help to clear up some of the new forces in the market that have confused investors and those writing or reporting on oil price movements.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.