Tunnel Vision Could Ruin Some Oil Investors As Bankruptcies Climb

| About: The United (USO)

Summary

Market only wants a rebalancing narrative - ignoring ongoing oversupply.

Investors need to continue to be cautious about suspect companies.

U.S. Shale still holds the price of oil hostage - will change the narrative if oil prices continue to rise.

Click to enlarge

source: Stock Photo

I'm increasingly concerned over the oil market, as it looks like it won't accept anything else than a positive spin on a rebalancing of supply and demand coming quickly, which it is assumed would boost the price of oil.

It's like the idea of oversupply is a thing of the past, with the media reporting inventory will be drawn down in the near future. This is spite of the fact a number of OPEC producers are increasing supply, and Iran outperforming the pace the market believed it could operate at.

For long-term investors in quality energy companies with a strong balance sheet and access to credit, this isn't as vital in the sense of losing capital; although it could result in even less dividends going forward. Where it could have the most effect will be on those investors who believe some of the weaker companies may survive because of the alleged change in supply in demand, which would allow them to improve in performance from the higher oil prices.

There is also the potential for those trading in and out of the market to take a hit if they believe the market is in a sustainable rebound.

Finally, it seems like - outside of a drop in shale production - the market has almost totally ignored the fact shale producers can ramp up production as the price of oil rises, which would increase supply and put downward pressure on oil prices.

Demand expectations

For some time the outlook for oil demand in 2016 has been for it to climb by 1.2 million barrels per day. Nothing has changed there from OPEC and the IEA, so it would mean the increase in supply, even though being said to be based upon an increase in demand, has to be to make up for the drop in production from producers in North America.

There are of course the temporary disruptions recently, but Canada will quickly bring production back to levels before the fires. Nigeria will continue to have some disruptions, but no competitor is going to boost production based upon that, as it is unpredictable and at times would put pressure on prices when Nigeria doesn't experience these types of attacks.

Libya is another factor, but it has only been producing at about a 400,000 per day rate since its internal strife began. Even if it suffers some loss, I don't see it having much of an impact on supply and demand.

As for the U.S., the production outlook seems to be slightly better than before, although it will still drop some through the remainder of 2016.

With Iran now exceeding expectations and Saudi Arabia and Kuwait ready to increase supply, it's hard to see why so many think the market is going to rebalance by the end of 2016. There should be an increase in demand during the busier summer months, but I don't see that being the catalyst that would align supply and demand with one another. In April Iran added 300,000 barrels in production per day, bringing its daily total to 3.56 million, according to the IEA.

Investors' beware

As mentioned earlier, the biggest concern I have is that investors will get overly optimistic from these dubious assertions and start to believe some companies that are weak have a chance to survive and maybe even thrive under conditions where the price of oil climbs to profitable levels.

Even if the positive scenario were to play out, it's too late for many upstream companies. Since I don't think a rebalancing is going to happen to the level being put forth, it is even more precarious for many U.S. producers. Ultra Petroleum Corp. and Linn Energy LLC are among the latest to file for bankruptcy protection, and Exco Resources said on Friday it hired advisers to look at alternatives for the company, among which includes a potential filing for bankruptcy. There will be more to come.

The point is even though we hear about the approximate 75 percent increase in oil prices from their low, it hasn't done anything to change the outcomes of these companies.

Other than top tier companies, I wouldn't maintain a position in any of the other oil producers at this time. I see it as dangerous to capital to make decisions on the supposed rebalancing right around the corner. At best it could temporarily boost prices, but it would also trigger many shale producers to complete wells and add to supply.

I don't believe a rebalancing will occur by the end of 2016, but even in the best-case scenario, the impact wouldn't be a positive one over the long term.

U.S. shale still controlling mid and upper price levels

U.S. shale will continue to hold the price of oil hostage, as will be evident if the price of oil jumps to levels where many of the mid-tier players are able to be profitable. That will bring a lot of oil to the market, which will push down the prices.

Saudi Arabia and others have stated for a long time they have no idea how to deal with this relatively new phenomenon. They can still keep the price of oil low by maintaining high production levels, but they can no longer have much, if any impact on the other price points. This why it's puzzling as to why it's considered a positive to see the price of oil rise, as if we're dealing with the same market we were several years ago. We're not.

What has been effectively done is to slow down the shale industry. Not only are there the obvious bankruptcies, but those companies that are more solid have had to cut back on CapEx, which will slow down some of the production once prices rebound. Even so, improved efficiencies have drastically cut costs at the better-run companies, and they are already bringing more wells to completion at these lower price levels. They'll bring a lot more into production if the price of oil jumps into the $50s.

Since we've really never been here before, it's impossible to know how much the additional shale supply will offset the cut in production from weaker competitors.

Conclusion

The strategy to slow down U.S. shale production has been successful, but it has the counteracting effect of raising the price of oil to a level many more shale producers may come back into the market. What is being attempted is to have the price of oil low enough to keep a significant portion of shale oil off the market, but high enough to slow down the loss in revenue traditional competitors have experienced over the last couple of years.

With that in mind, I don't see why the alleged 2016 rebalancing of the market is being considered so positive. Again, a lot of investors and financial media still don't get this is a disruption of the oil market, not simply another supply cycle. If the market rebalances it will bring a lot of shale oil to the market. That will in turn drive down the price once again.

I agree that supply and demand is the most important indicator for the price of oil, and rebalancing will eventually come. Oil demand will continue to climb under any scenario, and eventually it'll catch up with oversupply.

My conclusion is this isn't going to happen as soon as is being projected because there is still so much supply coming to market. I don't see it coming together that quickly. Investors need to be extra cautious concerning this current narrative, as it could give the sense of more security for weaker companies that could easily result in the loss of investment capital.

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.