Recent volatility in the crude oil market has caused much angst among producers and investors alike. The magnitude and ferocity of the plunge to near $27 caught many pundits by surprise. This begs the question "has oil hit bottom yet?" This analysis lays out the factors leading to a market bottom and the recovery episode that will inevitably happen in 2016/17.
To recap, since the fateful November 2014 OPEC decision to maintain output, defend their market share, and kill off high-cost producers around the world, particularly North American shale and oil sands, the drop in oil prices has been steady and relentless. A few meaningful developments have since unfolded including the rollover of U.S. production from the peak of 9.2MM bopd, the first Fed hike in ten years, the slowdown of worldwide demand growth, the lifting of U.S. crude oil export ban, and the intensification of geopolitical conflicts in the Middle East. Some of them are bullish and some are bearish but they collectively have not made a dent in the march downward. Worse still, they sometimes confound conventional wisdom: who would have thought an escalation of tension between Iran and Saudi Arabia could cause the oil price to drop? (For the uninitiated, it made it less likely for the two key OPEC members to coordinate oil output.)
The carnage has so far been very damaging to the American independent producers and some, for instance, ConocoPhillips (NYSE:COP) and Marathon Oil (NYSE:MRO) might have regretted their earlier decision to spin off their midstream and downstream refinery assets. Several metals mining giants seeking refuge in oil in recent years, including Freeport-McMoRan (NYSE:FCX) and BHP Billiton (BHP, BBL), have also been burned by the enormous investments they sank into oilfields across the U.S. This downturn has even claimed the seemingly invulnerable Master Limited Partnership (MLP) business model as victim, wiping out vast fortunes from the likes of Kinder Morgan (NYSE:KMI) and ONEOK (NYSE:OKS).
Sometime between late 2016 and early 2017 oil should be on the path of recovery, but not before making another visit to the $20s. There are several major catalyst events as shown in the chart. Although the sequence of events may not play out exactly as described, the theme and direction of travel are the points to be taken.
Iranian Oil Coming Back, 1Q/2Q16
How much? How fast? Those are the key questions. Since the lifting of sanction, investors have priced in about 500k bopd hitting the street right off the bat. This oil will come from ramped-up oil production as a result of months of preparation and the barrels currently stored in tankers off the coast of Iran, and will flood the marketplace that is already swimming in excess supply. The subsequent, sustainable increased production estimates are all over the place but mostly in the 200k bopd to 1MM bopd range. Although some impact has been factored in, the effect will be hard to gauge until the timing and quantities are better defined in the coming months. Regardless, this is very bearish for oil near term.
World Economy Wobbles, 2Q/3Q16
Emerging economies are already a basket case. China's transition from an investment-based economy to a consumption-based economy is going through a rough patch and a soft landing is questionable. European countries are suffering varying degrees of deflationary pressure and the European Central Bank has hinted at further monetary stimulus. The U.S. is looking increasingly likely to enter another recession despite a strong labor market. Although lower prices stimulate demand historically, most economists have recently posited that we are now past the point of diminishing return: most of the benefit of low oil prices has been taken advantage of and additional demand growth will have to come from more economic growth. What this means is that current crude oil and gasoline demand growth projection is likely to have been overestimated, and the market is going to realize this in the next few quarters. Score one for the bear.
North American Production Does Not Decline Fast Enough, 2Q/3Q16
Sometime during the next couple of quarters it will become apparent that oil-focused rigs are not being laid down fast enough to match the slowing demand, the negative sentiment, and the storage fill. The effect of increased rig efficiency and phenomenal production improvement resulting from oil shale ingenuity are going to linger for a while until natural decline kicks in meaningfully. In addition, zombie companies and oilfields that are running on negative cash flow are not shut down or shut-in at a fast enough pace. Meanwhile, projects in the Gulf of Mexico and Canadian oil sands that began in the boom years of the last decade continue to come online which offset the supply decline necessary for rebalancing to take place. Against the backdrop of a deteriorating economy and NAM not turning off the tap fast enough, sentiment is going to turn very sour and kick start a real bottoming process for oil. Now, what are the other big producers going to do about it? We turn to OPEC and Russia.
OPEC Meeting, June 2016
Since 2014 OPEC, especially the Saudis and the Emiratis, have insisted that non-OPEC producers (read: Russians and Americans) need to do their part in solving the oil glut. The key element of the strategy is to squeeze out the new higher-cost producers in North America to avoid a repeat of the 1980s when major investments in the North Sea and Gulf of Mexico (then enabled by high oil prices and new technology) paid off. So far it has been working but excruciatingly slowly. Who will blink first? Among big producers, the Iraqis and Russians have been pumping at record volume and Iranian oil is coming off a fresh sanction lift. What's common about them is they all need the revenue, badly. If left to their own devices, Game Theory says that they will all push as much oil as they can into the market to try to choke off others. And despite bleeding foreign reserve at a scary pace, the Saudi rulers have the determination and wherewithal to sit tight and wait another year or two while making minor social reforms to appease their citizens and achieve their original goal, which is to regain the market share and pricing power. With the shale genie already out of the bottle, it is much too late to put back in. So it will be a short-term victory but it is one that the Saudis want to achieve nonetheless.
Back to the June meeting, there will likely be symbolic gestures in the months before and after the meeting to "accommodate" the smaller OPEC producers and to lend verbal support to oil prices so as not to cause a total collapse. Nevertheless, the OPEC strategy will not be changed in any meaningful way until either the shale producers drop like flies or social unrest in the Saudi kingdom forces its hand.
Darkness Before Dawn
Thes events outlined above will be bearing down on oil prices in the first half of 2016. However, the major catalyst will likely be provided by the physical market running scarce on storage capacity, precipitating a panic. Next we will look at how it unfolds. Just as it is the darkest before dawn, the recovery will follow a sharp bottom.
Worldwide Storage Overflow (Almost), 2H16
While this is a much anticipated event, the timing is uncertain. About 2 million barrels of surplus oil need to find a home every day, but worldwide inventory has already exceeded historical high. Granted, outside the OECD storage capacity has never been properly documented. China has been ferociously building new storage infrastructure. Many floating storage facilities and tankers are being built or refurbished in recent years. It is, however, reasonable to assume that at current rate overflow is likely to happen within the year. The best way to gauge the level of saturation is by looking at the price difference between front-month oil contracts and future months which include storage costs. For now, contango is trending higher but not near historic high. If and when storage runs scarce, a large expansion of contango spread and intense selling (more intense than recent selloff) of front-month contracts can be expected and will likely herald in the real bottom.
The Bottoming 2H16-1H17
Many people are puzzled that since the 2MM bopd of surplus production today is much lower than the 1980s, why does it seem to take longer to bottom this time? The reasons are threefold. First of all, the Saudis were less willing and able to withstand the low price back then. Secondly, there is tremendous uncertainty associated with the end of both the commodity supercycle and the economic expansion since the Great Recession. Lastly, while the 2MM bopd is the headline number, the real party poopers are the massive production capacities lurking in the shadow, ready to be turned on, that have not been taken out.
There is not much debate about the unsustainability of current oil prices, but the timing of supply/demand rebalancing is the name of the game in 2016. Before the true bottom is reached, all the events described above will act as significant headwind to any recovery. While the compounding effect of Iranian oil, resilient North American oil production, and wobbly world economy is significant, the looming storage overflow in the physical market will likely provide the big jolt to the downside, helping to shake out all the weak hands and establish a bottom.
The Recovery 1H17
When the recovery finally comes it should be a fairly rapid run-up due to the sudden lack of sellers. Based on historical pattern, one can look forward to 50%+ in the first six months. Much of the current crash has been compared to the last supply shock which was in the 80s. If we assumed that the bottom for WTI is $22-25 then the initial pop would be to the high $30s. However, subsequent gain from there is not likely to be impressive. The reason is that in recent years the Americans have become the swing producers of the world, and their marginal cost of production has come down to the $40-50 range due to efficiency and technological gains. The nature of extracting shale oil has become a short-cycle manufacturing process so production can be ramped up or down in short order. In conjunction with the recent lifting of the crude oil export ban, this should result in the floor and ceiling being set more or less by American producers, absent intentional intervention from OPEC or major geopolitical events. This price range will have to be discovered in the next couple of years as supply/demand balances out and serious fiscal reforms are made in Saudi Arabia.
U.S. Dollar Strength
One overarching theme in 2016 is the strength of the U.S. dollar affecting worldwide equity, bond, and commodity markets. Since oil is priced in USD, its strength is a drag on any upward price movement. Although USD is expected to stay strong as the euro braces for more quantitative easing, the yuan being devaluated, and emerging markets suffer from continuing capital flight, it is believed that much of the damage has already been done in 2015. With that said, the WTI/USD correlation will weaken and 2016 is the year when fundamentals will drive the price of oil more than monetary and geopolitical influences.
What Can Change The Trajectory?
Looking beyond the relief bounce off of January low largely driven by short covering, the downside is the path of least resistance and presents favorable asymmetrical risk/reward for the next few months. The current sentiment is exceedingly bearish. There are, however, some extraordinary circumstances that may intercept the downward drift. If Russia and OPEC agree to cooperate on production cut, or social unrest flares up in Saudi Arabia to the point of changing their market share strategy, there will be meaningful reversal. Without these catalysts, oil is slated to head back down and stay there for a while.
The End is Nigh
In a way, the oil story is just another victim of the ending of the multi-decade commodity supercycle that clobbered copper, iron, gold, silver, coal, and many others. Excess production capacity built up over time takes many years to unwind and absorb. In the short term, producers, paradoxically, shove more products into the marketplace to attempt to replace lost revenue, thereby creating a downward spiral. More recently, natural gas suffered a similar fate of being the victim of its own success. The road to recovery can be long, but the end is almost in sight. When that day comes, those nimble U.S. shale oil producers with low debt, prime acreages, and sound hedges such as PDC Energy (NASDAQ:PDCE), Diamondback Energy (NASDAQ:FANG), Parsley Energy (NYSE:PE), Concho Resources (NYSE:CXO) will have the most upside. Many bigger producers and midstream players that have the financial resources to weather the storm and consolidate the industry such as EOG Resources (NYSE:EOG), ConocoPhillips, Noble Energy (NYSE:NBL), Energy Transfer Equity (NYSE:ETE), Enterprise Products Partners (NYSE:EPD) will also benefit disproportionately. Unfortunately for many smaller producers in weak financial position, this is the end of the road.
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.