The Current Oil Outlook: Is It Time To Start Buying Oil Companies?

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Includes: CHK, OIL, USO
by: David White

Summary

The EIA forecasts WTI oil price averages of $42.83/barrel for FY2016 and $51.82/barrel for FY2017.

Both the EIA and the IEA forecast demand catching up with and likely surpassing supply by sometime in 1H 2017.

Inventory levels have also been rising in the OECD and in China in recent years. This should tend to hold down oil prices a bit.

We have all witnessed the dramatic drop in oil prices over the last two years. This has led to severe weakness and even bankruptcies at many US oil companies. Prices of oil companies have dropped dramatically in the last two years. Many investors think these low oil prices cannot go on forever. Investors are looking for an oil price rebound and an oil company stock price rebound. Deciding when to invest in oil companies again is a dilemma many investors are facing.

A big factor in deciding when to invest in oil companies again is the future outlook for the world oil demand and supply. The two major agencies that try to predict this are the EIA (the US Energy Information Administration) and the IEA (the International Energy Agency). The chart from the EIA below shows the expectations most looked at by US investors.

In this chart the oil supply versus demand lines come closer together in 2016. Then in 2017 the demand becomes higher than the supply at least for a short time.

Below are two separate charts from the IEA from June 14, 2016. The first is the demand chart.

Click to enlarge

The second is the World Oil Supply chart from June 14, 2016.

Click to enlarge

The last two readings on the world supply chart above are for Q4 2015 and Q1 2016. They are respectively 97.18 mbpd and 96.49 mbpd. The last bar on the world demand chart was 96.87 mbpd for Q4 2015. The demand statistics are apparently not quite as up to date as the supply statistics. However, even the Q4 2015 levels are very close to each other. Plus the uptrend on the demand chart is a lot steeper than the uptrend on the supply chart. That would seem to indicate that the demand for oil will soon outstrip the supply.

Another IEA chart (see below) based on future estimates shows the IEA's view on oil supply and demand for the next few years.

In this chart it is clear that the IEA expects oil demand to outstrip supply for the next several years -- beginning in early 2017. That should be positive for higher oil prices; and it should be positive for US oil exploration and development companies. This agrees with the EIA chart far above.

Another factor which will play into oil prices for the near future is the level of inventories. The EIA chart below shows that inventories of Commercial Crude Oil and Other Liquids are already at high levels; and they are forecast to increase still further throughout FY2016 and 1H 2017.

OECD inventories were at 3.0B barrels at the end of 2015 (about 66 days of consumption). They are forecast to rise to 3.1B barrels by the end of 2016 and 3.11B barrels by the end of 2017. The higher than normal inventories levels should help to keep oil prices from rising rapidly. In addition, China diverted 787,000 bpd into its growing strategic petroleum reserve during Q1 2016. Even more new storage sites are under construction, so China is by no means done filling reserves, especially with oil prices this low. As of March 2016 China was importing 7.7 million bopd in total. Those approximately 90 days of diverted oil by themselves amount to approximately 70.83 million barrels of oil (or roughly 10 extra days of supply for China).

On top of all of the above there have been many unexpected disruptions in oil supply. The chart below from Goldman Sachs (NYSE:GS) gives a pictorial view of the approximate impacts of each.

These too have added to the upward pressure on oil prices.

Taking all of these things into account the EIA has forecast WTI oil prices to average $42.83/barrel in FY2016 and $51.82/barrel in FY2017. These numbers actually seem reasonable. Goldman Sachs recently said it expected WTI oil prices to average $45/barrel in Q2 2016 and $50/barrel in 2H 2016. That should be mildly bullish for oil companies.

Of course, oil followers know that the US can expand its production relatively quickly. It produced 9.43 mbopd in FY2015; and that was when it was trying to slow production down. The EIA forecasts US production of 8.60 mbopd in FY2016 and 8.19 mbopd in FY2017. The US has been cutting back on drilling considerably as prices have fallen. The rig count as of June 10, 2016 is down to 424 in the US. This is -433 from the year ago level. The US could easily ramp up its production; but expansion of significant US tight oil production is unlikely at the current price levels. It is not until the $70-$80/barrel price level that oil production becomes much more attractive for many US tight oil exploration and production companies. The current oil prices are really only semi-attractive for oil exploration and development for the lowest cost producers (the best companies in the US oil space). Hence I do not see US oil production or oil prices taking off soon. Plus the troubled production areas such as Nigeria, Libya, Canada, etc. may become untroubled, especially Canada. It has largely dealt with the huge forest fires.

That being said, almost anything could happen. For instance, the events in the hurricane season can often lead to higher oil prices. The Crown Weather Service as of May 14, 2016 was forecasting an ACE Index of 110 (or about a 10% worse than normal hurricane season for 2016). 2015 had an ACE Index of only 58, so the 2016 season is likely to be a lot worse. The Crown Weather Service was forecasting 8 hurricanes, with 3 of those hurricanes becoming major hurricanes (greater than Category 3 on the Saffir-Simpson scale). Depending on what actually happens, oil prices may rise over the summer. Thus far the forecast has been a miss; but we still have a lot of summer and fall to go. Hurricane season is June - November.

Investors should also take into account that banks want oil prices to rise. They will have fewer oil associated loans go bad if oil prices rise further. There will be fewer oil company bankruptcies. Since the banks are the "big money", the market may do what will cause the banks the least pain. Higher oil prices would also tend to save many marginal oil exploration and production companies from bankruptcy.

Some people don't believe in the above kind of logic. However, when the banks and other big money investors control a lot of the HFT programs, oil prices and prices of oil companies can be made to rise on short squeezes, etc. For example one of the biggest US tight oil producers, Chesapeake Energy (NYSE:CHK), has short interest of 23.91% of its float. For a company that seems almost sure to survive this low oil price debacle, CHK has a huge amount of short interest. Its stock price could easily be short squeezed upward on any oil price increase over the summer. However, this article is not a buy recommendation on any oil company.

I will try to write further articles that specifically attempt to examine the likely performance of a variety of oil and gas exploration and production companies in the current situation and the current outlook. Please look for them if you are interested. Remember that the equities markets often move up or down about 6 months in advance of actual events. If the above forecasts are at all accurate, now may be a good time to look at oil companies, especially ones that are not too weak.

NOTE: Some of the above fundamental fiscal data is from Yahoo Finance.

Good Luck Trading/Investing.

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.