Light At The End Of The Oil Price Tunnel - A Sequel

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Includes: COG, GEOS, MTZ, PXD, TRGP, WLL
by: James Hanshaw

Summary

The recent increase in oil prices is not likely to be substantially reversed because supply/demand fundamentals are balancing faster than I expected.

Major oil producers freeze on production coincides with production peaks and investments to increase production are not affordable without a significant oil price increase.

As the gap between supply and demand continues to close oil prices will rise taking the share price of producers and service companies up also.

When my article was published on February 11 I did not expect WTI to increase from $26.05 by some 50% in such a short time since. I do not know if current prices will hold in coming days but I do not see a return to the low prices we saw earlier this year. In that article I focused on demand meeting supply later this year causing an increase in prices with a big IF that an agreement by major non-US producers to modest production cuts would push prices even higher. Interestingly that big IF may no longer be necessary as production cuts by some are happening without such an agreement and a production freeze by major producers is near certainty. I will focus on those geopolitical points here by doing what I did then - endeavor to join numerous, diversely reported dots into a complete picture.

To those that show graphs depicting an oil price correlation with the US dollar - oil prices going down when the dollar goes up and vice versa - I would suggest they overlay that graph with supply and demand to see how that picture looks. In the US people's pay and costs are in dollars anyway. In the huge oil consuming EU - the world's second largest economy - taxes at the pump add 60 -80% to the price so fluctuations in the dollar value do not have a large impact on prices.

Taking the world's largest producer first, Saudi Arabia. I said it had shot itself in the foot. Among other things it was trying to protect its market share but has failed to do that as Iranian and US crude exports took market share from others including it. This March 28 article in the Financial Times has more on that. Joining a production freeze seems very magnanimous considering their hatred of Iran, who will not join the freeze, and their self-proclaimed war on US shale oil producers. However it could also be a face saving cover-up for the fact they cannot produce anymore. Saudi's output hit a record high in 2015 and is believed to have peaked then. Home consumption is also growing reducing the amount available for export. They may have plenty of reserves but those will take time and large investments to bring into production and they have little money available for that at existing price levels. Saudi is running a huge budget deficit at prices below $96 per barrel. It may have large financial reserves but it has cash flow issues meaning it has had to liquidate some long term investments, return to debt markets and delay payments to companies some of whom are needed to sustain production at existing levels from developed reserves that are depleting rapidly. I do not like commenting politics but do hope that those US presidential candidates who dislike fracking will join others in Washington and prevent Saudi Arabia, given its openly admitted attack on US shale producers, from increasing its stake in US oil refineries and prevent it from buying more in its blatant attempt to prevent US producers from increasing their sales in their own country.

Of other major producers, no one seems to know with any accuracy what Venezuela's current output is. It is a bankrupt, failed state and its oil output could tumble without outside financial aid which is not likely to be forthcoming in the near future. The IMF cannot help in the current political situation and China, who has helped in the past, is not likely to do so again given circumstances at home. Russia - the world's second largest producer - has little choice but to join the production freeze as its oil sector badly needs to invest to maintain output at current levels. Its largest producer has a mountain of debt and is cutting capital expenditures.

Other large producers have problems of their own. Libya's oil production has been decimated by internal war and there is no sign of that ending soon. Its production is down from around 1.6m b/d to less that 400,000 per day now. Political turmoil in Algeria and problems in Nigeria are threatening to reduce output from those countries. Low prices have meant that some of Petrobras' (NYSE:PBR) Brazilian reserves are too expensive to extract plus it also has mountains of debt and corruption problems preventing any significant increase in output.

Iran is often spotlighted as being about to spoil any gain from production freezes but facts suggest otherwise. Its oil minister said Iran would join the freeze when production reaches pre-sanction levels of 4m b/d. The International Energy Agency, IEA, said Iran's February production - the first full month since the lifting of sanctions - was 3.22m b/d of which 1.4 m b/d were exported. Not all of these were new exports as Iran has continued to supply countries like India that did not join the sanctions. That leaves 800,000 b/d for further exports and home consumption before Iran too freezes production. That will not impact much on prices with world demand running at 93 - 95m b/d and rising. Additionally its production infrastructure has been neglected and that will take time to rectify in order to increase from what are believed to be near maximum levels at 4m b/d.

Rystad Energy adds more to the story here

Turning to demand. China spends 2% of its large GDP on oil imports and those will grow as it cuts back on production at home due to its own reserves having become uneconomic at current prices. Car sales have slowed but are still expected to grow, from a large base, at 3-5% per year. There is much noise made of China's slowdown but I find it best to look at more reasoned views. China's official growth figures aim for 6.9%. In February S&P's chief economist made his own calculation of 6.3% GDP growth this year which he said is the equivalent of 14% growth as recently as 2009. To put that in perspective he said that would mean the UK - still a top ten world economy - growing at over 20%! The long dead EU is showing signs of life with very healthy car sales in most countries including some that have been very depressed such as Italy and Spain. Fast growing India is also becoming a big consumer of oil with all its needs being satisfied by imports.

In the world's largest economy - the US - the AAA reported that gasoline demand is higher than normal at this time of the year and the EIA said that in the 4 weeks to March 11 US gasoline consumption was 9.4m b/d, up from 8.3m b/d at the beginning of this year and 560,000 b/d more than at the same time in 2015. US refineries will have to ramp up production soon to meet that rising demand which is likely to continue in the summer months ahead.

There are some early signs of renewed investment - not much but maybe the first sign of light in that long, dark tunnel too. BP is expected to proceed with the Mad Dog 2 oil project in the Gulf of Mexico. Statoil (NYSE:STO) and Exxon (NYSE:XOM) recently said they will commence seismic surveys in a joint venture in deep water off the coast of Ireland. Hopefully that will bring work to one of my badly beaten up investments, Geospace Technologies (NASDAQ:GEOS). GEOS makes wireless seismic equipment and before the oil price crash fulfilled a very large order from Statoil which, hopefully, will lead to more. Those surveys maybe a prelude to new drilling. In my opinion, the oil majors must go after new reserves in deep water as shale oil, for the most part, does not suit their needs; the reserves are generally not large enough and depletion is rapid requiring high ongoing costs to maintain output. Shale is more suited to smaller, more nimble companies. They might be riskier but my preferences lie with them. Most of Saudi's reserves are now offshore and although not in deep water those will require drillers to get at them if investments start there again.

Since I am also heavily invested in US shale gas some of my oil investments reflect that. My favorites include Cabot Oil & Gas (NYSE:COG). COG has very large gas reserves in the Marcellus region and very good oil ones in the Eagle Ford shale. A recent addition is Pioneer Resources (NYSE:PXD) that has its main oil reserves in the Permian and good gas assets elsewhere. I also have Whiting Petroleum (NYSE:WLL) that has some of the largest reserves in the Bakken. I plan to buy into Helmerich & Payne (NYSE:HP) soon. I said that in my earlier article too and hesitated. There is an old saying that "he who hesitates is lost" and I lost a nice price gain by not buying sooner! The potential for more remains. It is the best onshore driller, in my view, and also has a stake in an offshore driller that I like, Atwood Oceanics (NYSE:ATW).

In the midstream sector I have Kinder Morgan (NYSE:KMI), Targa Resources (NYSE:TRGP) and Williams Companies (NYSE:WMB). Of those TRGP is my favorite as I think there is huge potential eventually at its LPG processing facilities. I also have infrastructure companies MasTec (NYSE:MTZ) and Matrix Services (NASDAQ:MTRX) that will gain when capex spending resumes.

Conclusions

My February article generated some very interesting responses from readers and I hope this one does too. Whether responses support or refute my views we can all learn from such discussions.

As oil prices improve I expect US shale producers to bring new production onstream gradually as any rush might put them back into the difficulties they partly caused with their success. I am sure those hard learned lessons will not be forgotten. Some bankruptcies are still likely but rising oil prices will give renewed confidence to banks and will proved excellent returns to those companies who have massively improved their efficiencies since the oil price crash.

Any recovery in oil prices and subsequent investment will be good for the US economy as a whole because part of the US manufacturing recession has been caused by the massive oil and gas capex spending cuts - over $200 billion - worldwide. I have investments in house builders KB Homes, (NYSE:KBH), LGI Homes, (NASDAQ:LGIH) and others that should benefit from that.

The IEA recently talked about an "oil shock" to prices that maybe caused by those capex cuts. That is strong language coming from an agency of that nature. On July 1st, 2014, WTI stood at $93 and Brent at $104. I do not know if prices will go back there but even without an "oil shock" I believe WTI will above $50 by year end and headed higher

Demand increases overtaking supply always pushes up commodity prices and that always encourages new investment until the cycle repeats again. As I see things today we are in the early stages of the next cycle. The light at the end of the oil price tunnel gets ever closer

Disclosure: I am/we are long COG,GEOS, PXD, KMI, TRGP, WMB, WLL.

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.