Crude Oil Poised For $60

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Includes: EPD, OIL, PCLN, USO
by: Sherli Looi

Summary

EIA forecasts global oil supply exceeds demand by 1.4 million barrels in first quarter of 2016, then to a zero gap in the second half of 2017.

This supply and demand gap can be easily closed with a 2% cut in oil production by the top 15 oil producers.

The secondary effects from higher oil prices have powerful positive financial consequences.

The solution to falling and lower oil prices is staring at the oil producers in their face!

The problem is caused by over production. The three largest oil producers in the world are US, Saudi Arabia and Russia. Together, they account for about 40% of the world's 2015 production based on EIA's October 2015 production data.

EIA's short term energy report also estimates that the excess supply is 1.4 million barrels of oil per day in the first quarter of 2016. Again, based on EIA's October 2015 production numbers, this excess supply can be erased by a mere 2 percent cut in oil production by the world's top 15 producers.

This is a very feasible course of action. This suggested 2% is much smaller than Russia's initial offer of a 5% cut. When the cut is spread amongst these 15 nations, the largest cut "endured" by the largest producer, US, is only 300 thousand barrels per day. This "sacrifice" makes complete economic and financial sense as it rapidly delivers real profits, reduces debt burdens and strengthens balance sheets. Refer to Table 1 and Table 2 below.

TABLE 1:

World
production

World
consumption

Implied stock
change
and balance

millions barrels per day

Q1 2015

94.6

92.7

1.9

Q2 2015

95.5

93.2

2.3

Q3 2015

96.4

94.9

1.5

Q4 2015

96.0

94.2

1.8

Q1 2016

95.3

93.9

1.4

Q2 2016

96.1

94.6

1.5

Q3 2016

96.6

95.8

0.7

Q4 2016

96.4

95.7

0.7

Q1 2017

95.8

95.3

0.4

Q2 2017

96.8

96.1

0.8

Q3 2017

97.3

97.3

0.0

Q4 2017

97.1

97.2

0.0

Source:

EIA

Click to enlarge

Table 2: Top 15 oil producers in October 2015

millions barrels per day

Production

Suggested Production

Oil Producers

Per Day

Cut per day

2.00%

1

United States

15.10

0.30

2

Saudi Arabia

12.05

0.24

3

Russia

10.91

0.22

4

China

4.68

0.09

5

Canada

4.41

0.09

6

Iraq

4.27

0.09

7

Brazil

3.52

0.07

8

United Arab
Emirates

3.47

0.07

9

Iran

3.45

0.07

10

Kuwait

2.70

0.05

11

Venezuela

2.69

0.05

12

Mexico

2.63

0.05

13

Nigeria

2.38

0.05

14

Qatar

2.06

0.04

15

Norway

2.03

0.04

76.35

1.53

Source: US Energy Information Administration

Click to enlarge

It really behooves the top oil producing nations mentioned in Table 2 to implement the 2% production cuts immediately because they stand to enjoy tremendous gains. The secondary effects from higher oil prices have powerful positive financial consequences:

The equity markets which have recently fallen in tandem with the drop in oil price, would now improve because sovereign oil nations which were forced to sell their equity assets to pay for their budget deficits, no longer need to do so.

The US dollar strength will moderate, given its inverse relationship with oil prices. This will help US companies register better profits. A case in point: Priceline.com (NASDAQ:PCLN) would be one of the major beneficiaries of a weaker US Dollar exchange rate. In the past two years, in spite of its great business model, their revenue growth rates were in the mid-teens instead of mid-twenties, mostly due to foreign exchange headwinds.

The overall earnings in the widely tracked S&P 500 would enjoy positive growth, spurred by the oil & gas exploration and production companies, which would enjoy both positive cash flow and a revaluation of their marked down reserves. Although not a pure E&P company, Enterprise Products Partners LP (NYSE:EPD), owns an oil and gas infrastructure company with a strong balance sheet. 70 percent of its customers are investment grade, and trading at 36% from its 52-week high delivers an attractive 6.9% dividend yield.

High yield and junk bonds would recover from the recent sell-off.

Higher oil prices help produce higher inflation, enabling the Federal Reserve to resume their policy of increasing interest rates. This risk reward recalibration back to normal is desperately needed after 7 years of easy money.

Why $60 per barrel oil?

In the short to medium term, this initial target is based on several considerations:

From a fundamental perspective, prices much higher than this level would encourage over production again, re-initiating the whole cycle, breaking the cooperation among the nations to continue with their production cuts. The forces of supply and demand would cap oil price, unless the world's GDP surprises strongly to the upside, and China begins its economic recovery. Given its current issues of excessive credit, weak export demand, excess capacity, fund outflows and capricious investment policies, this scenario is unlikely in the foreseeable future.

The buildup in global oil inventories will be an overhang, and a ceiling to oil prices in the short term.

From a technical perspective, the fall from $112 oil price in August 2013 to the recent $26 low has unfolded in a classic 5 wave formation, according to the Elliot Wave Theory.

Based on this technical interpretation, oil price may most likely bottom in the $25-$20 range. This scenario will materialize if the top oil producing nations fail to bite the bullet of production cuts.

Additionally, with storage capacity operating at almost 100%, even freezing production to January levels, as reported by some media, will pressure oil prices. Essentially, excess supply must be erased, and ideally, demand then outweighs supply by a few hundred thousand barrels of oil per day to reduce inventory overhang and drive the oil prices higher.

If oil indeed bottoms around $22-$25, a 50% retracement of that entire move is about $60-$65.

Conclusion: The fundamentals of supply and demand, the recent indications from the two major oil producers, Saudi Arabia and Russia, combined with technical perspectives all indicate that the oil price is likely to find a bottom soon. Given the risk of another $10 drop from the current levels, and a potential $30 rally in the price of oil, investing in beaten down oil stocks with good balance sheets is a no brainer.

Disclosure: I am/we are long PCLN, EPD.

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.