The Future Price Of Oil

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Mark Bern, CFA

Summary

Short to intermediate term price is likely to remain depressed once the myth surrounding OPEC and Russia supply cuts is unmasked.

Waiting for the "real" bottom can be frustrating and wear on the patience of most investors but the long-term payoff should be worth the aggravation.

The price of oil is likely to be range bound for many years but the range may improve to profitable level by late 2017.

This article represents an update to a three-article series I wrote last year during July which I linked to in my Energy Sector Outlook instablog. The first of those articles provided a historical account of the price of oil back to the 1970s for perspective while the other two focused on my expectations for future pricing in oil and natural gas, including the rationale. As time passes we often learn more and connect more dots, thanks in large part to other Seeking Alpha authors.

In this article I will focus entirely on the price of oil over the near to long term and what may cause the gyrations and the factors that should keep the price relatively range-bound for several more years. I will start by trying to sort out the current situation and what to expect through the end of 2016.

Demand

Obviously, demand and supply will always be factors that affect price; simple economics. But today, I believe there are other factors at work that will be discussed a in a later section of the article. The low price of oil, in U.S. dollar terms, helps to increase consumption in the U.S. Demand in the U.S. is rising, but there are headwinds that did not exist a few decades ago.

Conservation efforts by individuals, companies and governments continue to reduce dependence on oil and thus counteract some of the increased demand that would otherwise be created by low prices. There are more electric cars and hybrids on the road today and, among gasoline-powered vehicles, efficiency improvements have been increasing the average miles per gallon obtained by passenger cars sold in the U.S. With the price at the pump so low, more Americans are opting to buy the less efficient pickups and sport utility vehicles. So, the full impact of more fuel-efficient autos is not being fully captured.

In the aggregate, demand is rising but not by as much as would be expected if all other factors were static. But that is the point: the economy is changing, albeit slowly, but all the factors involved are moving. To hold one as unchanging is not a true reflection of reality. Thus, all the forecasts we read are merely modeled estimates using assumptions determined by people. Most, if not all, people have biases that color their respective expectations and, by extension, the assumptions that are used as inputs to the models. None are going to be perfect. Sometimes one gets lucky and gets close; probably the result of a less strong bias.

But U.S. demand is not the only driver of the price of oil. China has experienced a growing appetite for all forms of energy resources, including oil. But demand in China is slowing; probably much more than officials want to admit. Several countries are either in recession or experiencing extremely slow growth: Russia, Brazil, Venezuela, Argentina Ecuador and Greece are all in negative or no growth territory for 2016. The Eurozone is expected to grow at a rate of 1.7 percent with Germany, the engine of European growth, forecast to grow at 1.8 percent. Greece is not the only economy bringing the average down.

My point is that even though the global economy is expected to grow in 2016, the rate of growth compared to past years is slowing. Thus, the increase in demand for more oil will also be growing more slowly. I have noticed several downward revisions from multiple entities for global GDP growth in 2016. All seem to think that the first half will be slow but growth will pick up in the second half of the year. Then, by 2017, the global economy will be on better footing and growth will pick up again. I cannot help but be skeptical because over the last two or three years the forecast was almost exactly the same. At the beginning of last year the prognosticators were forecasting U.S. growth to be at three percent in the fourth quarter. How did that turn out? Again, many projections of demand for oil are based upon what I suspect is optimistic economic growth that may not materialize. Thus, demand may continue to grow but probably at a much slower pace.

Supply

First, we again need to define the current situation. We began 2015 with world oil production of 79.4 million barrels of oil per day [bpd] in January and ended the year with production of 80.6 million bpd in December. Early in 2015 many were predicting that global production would fall by year end. It did not happen. The region that would see the most dramatic drop in production was to be the U.S. Oil production in the U.S in January 2015 was 9.3 million bpd and ended up at 9.3 million bpd in December. The average production in the U.S. for 2015 was 9.4 million bpd. Now the projections are for U.S. oil production to fall by about 530 thousand bpd according to the International Energy Agency. The same organization expected a significant drop in U.S. production in 2015. I think production will fall in the U.S. but I am not convinced that the drop will be as large. Many producers of oil need the cash to service debt and will only stop producing when the money completely runs out and the entities are forced into bankruptcy.

A recent report by the Energy Information Agency (at eia.gov) projects that the average surplus of the global oil supply will be 1.6 million bpd in 2016 and 0.6 million bpd in 2017. This report takes into consideration all known new supplies coming into the market as well as expected growth in demand. It also considers reduced production at existing wells.

Plain and simple, the above report means that the glut in supply is expected to continue well into 2017 before supply and demand can rebalance. That does not suggest rising oil prices and time soon.

Price support efforts

An article by someone another Seeking Alpha contributor who should know about oil, Chris Cook, seems to suggest that the Saudis and perhaps other Persian Gulf producers may have been using financial instruments to prop up the price of oil artificially. It is well known that OPEC and Russia have been announcing meetings to cap production and that the market seems to somehow think that this will lead to supply reductions soon. I have been following OPEC meetings since 1974 and there have been very few instances when expected or announced reductions actually lived up to the hype. Most OPEC members will cheat on quotas now as in the past. They need the money. If the price spikes on expectation to more than $50 per barrel it will likely lead to increased production rather than sustained reductions in supply, both by OPEC members and by producing countries outside the cartel.

Artificial price supports and meeting rumors may inflate the price of oil temporarily as we have witnessed in the recent weeks, but such efforts will not be able to sustain the price of oil above $40 for very long.

Expect a price range for the foreseeable future

For the next year to 18 months I expect the price of oil to fluctuate primarily within a range of $30 - $40 with potential temporary spikes above and below. If the meetings planned by Russia and OPEC turn out to be nonproductive in terms of reductions, an outcome I expect is highly probably, we may see oil inventories continue the unrelenting rise resulting in another new low in price. Conversely, if the meetings do turn out to be productive and result in meaningful cuts in supply the price could rise to a higher range earlier than I expect. Anything is possible. However, I would not suggest the later to be the probable outcome no matter how many times we are told that agreements have been made. There may be agreements but those who sign will be unlikely to hold intentions to abide. That would mean giving up market share and allowing other producers to fill the void.

Further, it will take months to work through the excess supplies already in inventory around the world both on land and in floating storage. If the price were to rise above $50 per barrel there are several low cost shale producers who would gladly hedge their future production several years out and begin to drill again. The price of oil may rise as high as $80 per barrel temporarily but if it does it will mean more production coming to fill any gaps allowed by those who have reduced production. The gains will be only temporary and will only result in another glut.

Beyond 2017 it is true that cuts in current capital expenditures will allow supply and demand to rebalance as demand rises faster than new supply from traditional long lasting sources can be brought online. But shale, for as long as it may last, will keep the price of oil capped below $100 for many years to come. Shale production can be increased much faster than traditional wells and far more quickly than deep water wells. The cost in several U.S. shale fields is coming down and is below $30 in some areas.

I still believe that there will be a large number of small and medium sized E&P companies that will go bankrupt with their larger brethren picking up the assets on the cheap. This process could take a couple of years to play out, maybe even longer. As the bad debts are wiped away for the new owners the cost come down even more and, in time, more advances in technology will bring the average cost of producing shale down from over $60 last year to below $50 in the not so distant future. The best fields may then be able to produce oil below $25 per barrel. The players may change over time but the U.S. will remain a major oil producer and the wild card in the global supply that keeps the price of oil from rising to lofty levels.

Whenever the price is above $60 drilling rigs will be put to work again. Production does not happen at the drop of a hat, but the lead time should keep prices capped below $80. As more of the assets of failed producers are consolidated by larger oil companies like Exxon Mobile (NYSE:XOM) or Occidental Petroleum (NYSE:OXY) U.S. supply will be more managed to keep the price from falling to unprofitable levels. That should keep the price above $45 for the most part.

Summary

I expect the price of oil to hover primarily between $30 and $40 throughout 2016 and well into 2017. Once supply and demand are brought back into balance (not before mid-2017 at the earliest) I expect the range to rise to between $45 and $80 (averaging around $60 per barrel) through at least 2020, barring any major geopolitical events.

Disclosure: I am/we are long XOM.

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.