Revisiting The Bull Case For Oil

| About: The United (USO)

By Saurin Shah, Associate Portfolio Manager, Global Equity Team

Recent turbulence in oil prices is a reminder of the bearish voices in some corners of today's energy market. OPEC's fading effectiveness, high inventory levels and economic stagnation are among the concerns that some feel could drive oil prices down - way down. We have been skeptical about the energy sector for some time, and are cognizant of various risks to oil prices. Still, we believe the most likely trajectory of oil from here is up, for a number of reasons that we outline in this paper - although we caution that the path ahead is unlikely to be linear.

Along with this year's surge in,1 and subsequent pressure on, oil prices has come a dose of skepticism, which centers around whether supply growth can slow as much as anticipated, and whether the sluggish global economy can absorb that growth. Some paint the picture particularly starkly, arguing that oil prices could fall back to as low as $10-20 per barrel, which is the cash cost to produce new barrels from existing oil wells, before the market reaches "equilibrium."

This pessimistic view rests on several beliefs:

  • OPEC has lost its effectiveness as a cartel, as members compete for market share by boosting production;
  • Excess supply conditions are likely to persist as demand remains soft;
  • Inventory levels remain elevated in the U.S. and globally;
  • Lenders are keeping borrowers afloat, allowing them to maintain production to service interest payments; and
  • A stronger dollar could raise the cost of oil in developing countries, thereby depressing demand and, by extension, prices.

Prices did fall to less than $30 per barrel earlier this year, but that was due to a confluence of factors that we believe are unlikely to be repeated: heightened concern about a Chinese hard landing, the warmest winter in several decades for many OECD countries, slow adjustments to U.S. supply (due to hedges, availability of financing, efficiency gains and a shift in production mix to more economically viable wells), a sharp devaluation of the Russian ruble (over 30%) which kept costs low and led to production gains there, production additions from Saudi Arabia, Iran and Iraq, a surprising lack of any major outages, and extreme contango (where near-term delivery contracts are cheaper than future contacts), which led to huge short positions in crude and massive storage builds.

As we look ahead, we find numerous reasons to suggest that oil prices will not fall to cash costs. Instead, we think they are likely to move higher-due to robust demand and several other factors, including capex reductions that are helping to tighten supply. Below, we explore these factors in greater detail, highlight the risks to our expectation of higher oil prices and explain how these dynamics are affecting our investment perspective.

1. Global oil surplus is relatively small, so shut-ins are not needed

Oil is different from other commodities in several respects. First, there is a natural decline rate in producing oil fields - estimated to be in the range of 5-8% globally, and much higher in U.S. shale (20-50%).2 This decline rate means new investment and discoveries are required each year for adequate reserve replacement just to meet existing demand. Second, unlike metals that can be recycled from scrap, oil cannot be reused, and there is no major substitute for oil - especially in its most important usage sector, transportation. Third, and most importantly, according to the International Energy Agency (IEA), the current global oversupply in petroleum is only about 1.4% of first-quarter 2016 consumption of 95 million barrels per day. With production falling in response to lower prices, and consumption rising for the same reason, the IEA estimates a 2016 surplus of 0.3% of consumption, and forecasts that the surplus will be eliminated in the second half of 2016 (see Figure 1). The agency anticipates a supply deficit in the second half of 2017, which we believe will have to be filled by inventory drawdowns, U.S. shale and additional OPEC production.

Figure 1: Oil Surplus Could Fade in the Second Half of 2016

(Source: International Energy Agency)

2. Demand is robust

Global demand growth did dip in the second and third quarters of 2014, but overall, it rose by 1 million barrels per day for the year, accelerating to 1.8 million barrels per day in 2015 as economic conditions improved and consumers bought more fuel-intensive vehicles. In the first quarter of 2016, demand grew by 1.5 million barrels per day, and it is projected to grow by 1.2-1.3 million barrels per day on average for the full year by the IEA (see Figure 2).

Figure 2: Demand Keeps Growing

Global Oil Demand (MMb/d)

(Source: International Energy Agency)

Despite concerns about the Chinese economy, Asia remains the fastest-growing region for oil demand, with growth of nearly 1.0 million barrels per day in the first quarter, and India's contribution to growth now anticipated to be roughly equivalent to China's (see Figure 3). In 2015, Asia's oil consumption grew by 1.2 million barrels per day - nearly double its level of growth in 2014.

Figure 3: India Is Joining China as a Key Growth Market for Oil

Incremental Demand for Oil

(Source: International Energy Agency and Bloomberg)

3. Supply is tightening

U.S. energy production has already fallen by about 0.8 million barrels per day from its peak in April 2015, according to the U.S. Energy Information Administration (EIA), since the summer of 2015 (through April 2016), and is expected to decline further as a result of lower prices and capital investment. The EIA forecasts U.S. production to fall from an average of 9.4 million barrels per day in 2015 to 8.6 million barrels per day in 2017. The U.S. oil rig count has dropped sharply from a peak of 1,650 in 2014 to 371 in late July 2016 (see Figure 4). Mexico is also expected to experience a 0.5 million barrel/day decline in production in 2016, which could further help offset increases from Saudi Arabia, Iran and Iraq. Overall, the IEA sees non-OPEC crude production falling by 2%, from 53.2 million barrels per day in 2015 to 52.1 million barrels per day in 2016. As Figure 5 shows, total supply declined by over 0.9 million barrels per day in May 2016 versus a year ago, as non-OPEC production fell by 1.5 million barrels per day and OPEC's rate of production growth has slowed. Additionally, the overall estimated spare capacity of OPEC has declined from a recent peak of 6 million barrels per day in 2014 to 3 million in May 2016 (as the Gulf states have expanded production), and it is expected to fall further - which indicates that there is only a small buffer to meet any potential demand surge or supply outages (see Figure 5).

Figure 4: The U.S. Rig Count Points to North American Production Decline

U.S. Oil Rigs

(Source: Bloomberg. Bakeoil Index (Baker Hughes U.S. crude oil rotary rig count). Data through July 22, 2016.)

Figure 5: The Supply Picture Is Tightening

Change in Total Supply of Oil
(YoY Change, MMb/d)

OPEC Spare
Capacity (MMb/d)

Annual Oil Production Deferral (MMb/d)

(Source: International Energy Agency and Schlumberger)

4. Capex has fallen sharply, and incentive prices (not cash costs) may matter most

It is difficult to obtain a precise aggregate level of capital spending by the global oil & gas industry. However, we can estimate the exploration and production spending by the industry based on survey data (although the estimates vary based on the sample methodology employed). Evercore ISI and Schlumberger, which have tracked capital budgets at exploration and production (E&P) companies over many years, observe that E&P spending has been cut by over 40% since its peak in 2014, resulting in an approximate $275 billion reduction in spending (see Figure 6). Wood Mackenzie, a research firm, believes that the total extent of oil & gas projects canceled or deferred since 2014 is even greater, at about $400 billion. While these estimates vary, they all point to a decline that is larger than any since the 1970s. This decline will reduce production growth in 2017-2020. Schlumberger estimates that 2020 production will probably be 3 million barrels per day lower than it would have been otherwise (see Figure 5).

Questions actively debated within the industry include what oil price is required for overall production and capital expenditures to increase, how long that price level would have to be sustained, and how quickly rigs and crews could be mobilized in any price upswing. Several estimates suggest that the incentive price for finding, developing and producing the incremental barrel to satisfy marginal demand is in the $50-70 range.4 According to EOG Resources, a leading U.S. shale producer, a sustained price of $60-65 per barrel is needed for U.S. shale production to grow. If these estimates are correct, oil prices would have to rise to this level - and stay there - if companies are to be motivated to make the additional investment needed to offset declines and meet future demand.

Figure 6: Oil Capital Expenditures Are in Sharp Decline

Global E&P Spending, 1985-2016E ($ Billions)

(Source: Evercore ISI)

5. Discoveries have fallen to all-time lows

Beyond offsetting natural decline rates from existing oil fields, energy companies face a shortfall in new discoveries as well. Consulting firm IHS Inc. recently determined that the industry had found just 2.8 billion barrels of crude and related liquids last year - the lowest annual volume of new global oil discoveries in over 60 years5 - as oil & gas companies have drastically reduced exploration spending in order to conserve cash. With exploration budgets still under pressure, it is unlikely the industry will be able to report large, new discoveries in the medium term. Shale oil in the U.S. has reduced the immediate need for large, conventional discoveries, but it has relatively high decline rates, which means the industry will likely need additional sources of supply in the medium term.

6. Bankruptcies have risen, and financing is more challenging

As of May 31, 2016, 81 North American oil & gas producers that have filed for bankruptcy since the start of 2015, according to law firm Haynes and Boone. These bankruptcies involve approximately $52.6 billion in cumulative secured and unsecured debt. Of the 81 bankruptcies, 39 producers have filed for bankruptcy this year; these companies had $35 billion in liabilities, and some of them were listed publicly. As hedges roll off, and despite the bounce in prices, we believe more filings are likely in the months ahead.

While the oil reserves of these producers could reemerge from the Chapter 11 process, it will take time, adding to the difficulties of increasing production. Tighter credit from banks, more cautious managers and more demanding securities markets add to the challenges. Although most U.S. production is by investment-grade companies, even some of these producers found capital markets more challenging in recent quarters. Ultra-low rates and the rebound in oil prices have improved financial conditions for the sector more recently, but heightened price volatility could a risk, especially for higher-cost/more indebted companies.

7. Outages have risen

Unlike the prior few years, there have been several supply disruptions in 2016 - from a three-day worker strike in Kuwait, to military unrest in the Nigerian delta (0.2 million barrels per day), wildfires in the main Canadian oil sands region (1.1 million barrels) and political strife in Libya (taking another 0.2 million barrels away from that country, which was already producing at historically low levels). While the price impact has been limited to date, the system may not be able to handle future disruptions without price hikes, especially as the level of global stocks/inventories diminishes. This is a possibility that extreme bears may not be considering. Venezuela is another country that could be susceptible to a supply outage in the near term.

8. Inventories, although high, have started to fall in the U.S., and are likely a lagging indicator of prices

Despite the factors we've noted, global oil inventories remain high in the U.S. and other OECD countries - both U.S. and OECD stocks are well above their 10-year average ranges. Although inventories have just recently started to decline, especially in the United States, the IEA estimates that the adjustment process could take more than a year. However, it is debatable whether inventories are leading or lagging indicators of oil prices. The energy analysts on Neuberger Berman's Global Equity Research team believe inventories are lagging indicators, and that the market is more focused on the supply/demand picture. As a result, we believe oil prices can rise ahead of a normalization in the level of inventories. As Figure 7 shows, price moves have often foreshadowed inventory changes - rather than the other way around.

Figure 7: Inventories Don't Appear to Lead Prices

WTI Price vs. U.S. Crude Inventory

(Source: Neuberger Berman)

9. Speculative positions have changed, and the extreme contango has diminished

Short interest in oil & gas and related fuels was significant in late 2015 and early 2016. However, in the wake of supply declines, disruptions and demand increases, these shorts have generally been covered such that the market was net long at the end of May 2016. Meanwhile, the forward curves to 2020 have moved up $5-10 per barrel since mid-January. Also, extreme contango (in which near-term delivery contracts are cheaper than future contacts) conditions that prevailed in late 2015 and early 2016, which incentivized producers to accelerate production and store it for future sale and delivery, have eased (see Figure 8). With the market moving toward backwardation (in which longer-dated forward prices are lower than near-term prices), the pressure on storage should abate, making the downward price pressure that some have anticipated from fire sales of bloated inventories less likely.

Figure 8: Fading Contango Reduces Pressure to Produce

Spread between 1-Month and 12-Month Crude Oil (Brent) Futures Prices

(Source: Bloomberg)

Risks to Upside View

There are several risks to a thesis of an upward movement in oil prices over the coming months. First, the dollar could strengthen due to a number of economic and geopolitical factors, which would likely result in lower commodity prices, including those for oil & gas. However, U.S. dollar appreciation would most likely be the result of Federal Reserve interest rate hikes - and given weak U.S. and global growth, the upward path of rates is unclear. Second, although it is not our base case, a global recession could lower demand and prices. While these are both plausible risks, we don't believe they will bring oil prices down by more than $10 per barrel from current levels on a sustained basis.

We discount the possibility that the energy sector could add supply faster than currently anticipated. There are many drilled but uncompleted wells in the U.S. that are relatively easy to bring on-line, but it is not clear whether owners will do this in the absence of higher prices, and how quickly crews and rigs could be deployed. An additional risk is that some OPEC producers (Saudi Arabia, Iran and Iraq) could expand production further than is widely expected, and that other non-OPEC producers (Russia) somehow manage to offset declines.

Investment Implications

Over the past two years, the Neuberger Berman Global Equity team has maintained a cautious view on the energy sector. Returns on capital in the market have suffered from a combination of lower oil prices, elevated costs and excessive capital expenditure. Reflecting this, the sector has been a significant underperformer, with the MSCI ACWI Energy index down 29% from June 30, 2014 to June 30, 2016, versus the MSCI ACWI's overall performance of negative 2%.7

However, in the current low oil price environment, we believe many of these challenges are in the process of being resolved - oil firms have reduced their cost structures, pressured suppliers, cut capex significantly and are benefitting from commodity prices that appear to have reached a floor. As a result, we have become incrementally more positive on the sector, favoring companies that we believe have healthy reserve levels, low-cost production and strict capital discipline. We think companies with strong balance sheets and recurring cash flow from downstream (refining and marketing) activities offer lower risks than those focused solely on upstream exploration and production. With the energy marketplace looking past its worst, we think it is time for diversified global equity portfolios to look past the remaining skepticism and consider adding selectively to energy holdings.

1 According to Bloomberg, spot oil prices in U.S. dollar terms, as measured by Brent crude, rose by approximately 76% from January 20-June 30, 2016.
2 The U.S. Energy Information Administration's estimates of the decline rates for U.S. shale vary considerably by region; also, because initial-year declines can be as high as 70%, the average life of wells drilled is an important factor in their determination.
3 Barrel of oil equivalent, as of April 2016. Monthly data reports have a significant lag. More timely (if less comprehensive) weekly data point to a decline of 1.2 million barrels per day in mid-July 2016 from a year earlier.
4 Source: Alliance Bernstein and Goldman Sachs.
5 Source: Ed Crooks, "Oil Discoveries Slump to 60-year Low," May 8, 2016, Financial Times.
6 Source: Societe Generale SA.
7 Source: Bloomberg. MSCI ACWI and MSCI ACWI Energy indices.

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