The Time To Invest In Crude Oil Production Is Nigh

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Includes: CPE, EPD, FANG, PAA, PE, TOT, TSLA, VDE, VGENX, XOM
by: Dirk Leach

Summary

Global consumption of crude oil continues to grow and the US Energy Information Administration's growth forecast I believe is low.

Annual growth rates of auto sales in China and India are in the double digits.

US vehicle miles traveled are hitting all time highs.

Investment in new crude production has decreased significantly.

Crude consumption will balance and exceed production likely in 2017.

Some recent articles on Seeking Alpha (example here) have offered up the idea that oil is range bound between $40 and $50 per barrel through 2017. Further, that demand growth is decreasing "2016 it'll drop to a growth pace of 1.3 million barrels per day, and for 2017, fall to 1.2 million barrels per day," those numbers being borrowed from a recent report by the US Energy Information Administration (NYSEMKT:EIA). To the contrary, it appears to me that the EIA is underestimating global crude oil demand growth, having failed to factor in growing transportation demands in emerging economies, the growth in passenger miles driven in the US, and the decrease in average vehicle mileage.

Despite the last couple of week's wobbly crude oil market pricing, I'm bullish on the future prospects for crude oil and the E&P companies that produce it. The most profitable investments I've made over the last 30+ years have been based on macro trends that move whole sectors and entire economies. This article presents why I believe we will see steady and continued improvement in the price of crude oil and the valuations of the companies that produce it.

Growth in Global Consumption

Despite all the hand wringing and pontification over China's economic growth and its potential impact on global crude oil consumption, the growth in consumption of crude continues constant and unabated. The chart below, compliments of the EIA, shows consumption growth since the year 2000 through 2017 (forecast).

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To most people, the graph shows a fairly constant growth rate of around 1.4M barrels per day year over year with the exception of the slight dip in 2008-2009. If you actually look at the underlying numbers that make up the graph you will find that the slope of the line from 2000 to 2007 is 1.41M barrels per day. For the period 2009 to 2017, the slope is 1.47M barrels per day year over year. Consumption growth is not decelerating, it is accelerating. I think this can be explained by the growth of personal vehicle ownership in the emerging economies.

Astute readers will probably ask the question, how much of the crude oil produced ends up being used for transportation fuel. In 1973, about 45% of all crude production was used for transportation. Today, that percentage is 65% and growing. So, about two thirds of all crude winds up being used as transportation fuel. While it does not represent an entire barrel of crude, we can look at transportation usage growth as a proxy for crude consumption.

If we look only at China's and India's light duty vehicle sales, we find continued double digit growth in both.

I included a trendline on both charts. While it appears that India's grow in auto sales might have slowed over the last year, it was still more than a 16% increase from 2015 to 2016 (estimated). With growth like that in the emerging markets, it is no wonder that global crude consumption continues to grow.

Vehicle sales in Europe and the US have slowed recently from their 2015 pace but remain healthy. Sales of SUV's and light trucks in the US are still very strong, cars not so much. The chart below shows the sales of cars, SUVs, and light trucks in the US for 2016 through August.

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Clearly, US consumers are showing a preference for larger, heavier, and thirstier vehicles with light duty trucks leading in sales. This preference for thirstier vehicles is putting the new CAFE standards in jeopardy of not being met. Average fuel efficiency of cars on the road in the US has been dropping for the last few months.

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As more trucks and SUVs are produced and sold the fleet average fuel efficiency in the US will continue to drop. In addition to buying larger and less fuel efficient vehicles, the US population is logging more miles than ever before. The chart below shows the 12 month moving average of miles driven from 2000 to 2016.

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Though some people point to the younger generations preferring to use mass transportation and foregoing personal vehicle ownership, it is not reducing the total miles driven. In looking closely at the chart, the trend over the last two years shows the growth in miles driven has actually accelerated. This is likely due to lower costs for gasoline and diesel. Cheaper fuel translates into people driving more.

Lack of Investment in Future Supply

Two years of low oil prices has taken a significant toll on oil and gas (O&G) capital expenditures (capex). Estimates run as high as $400B for O&G projects that have been delayed or cancelled over the last two years. Because the price of oil has remained low, capex budgets are still being cut. Today, investment in exploration and production is below that which is necessary to make up for declines in existing fields let alone provide for any growth in global consumption. With maintenance and enhanced recovery, a conventional field's production declines roughly 2.5% to 3.5% per year. Without maintenance and/or enhanced recovery, a conventional field's production declines as much as 6.5% per year. Tight (shale) oil fields can have decline rates as high as 5% to 7% per month during the first year. Without investment to find new reserves and production, the natural decline of existing fields will reduce supply buy roughly 3 - 4 M barrels per day per year.

Balance Between Consumption and Supply

The EIA has estimated that production and consumption will balance either in late 2016 or during the first half of 2017. The EIA chart below shows the forecast for production and consumption.

I'm not going to attempt to refine what the EIA has done with their consumption and production data and chart. There are simply too many variables that affect both production and consumption and the two lines on the chart above begin to converge in 1Q17 and show consumption exceeding supply before 3Q17. However, the EIA recently lowered their forecast of consumption growth for 2016 to 1.3M barrels per day and to 1.2M barrels per day for 2017. Given the continued double digit growth in emerging market auto sales, the increased sales of light trucks and SUVs in the US, the drop in sales adjusted CAFE mileage rates, and the continued growth in total miles driven in the US, I don't see any headwinds on consumption growth. Actually, all of the impacts I see are tailwinds pushing consumption growth higher. So, I think the EIA's latest downward revision to consumption growth is without much of a basis.

The Potential Impact from EVs

It is very frequent that articles presenting the case for a recovery in crude pricing collect a number of posts from people that believe that EVs will soon displace a significant amount of the crude oil currently used for transportation. While I expect EV sales and use to continue to grow, I don't expect that EVs will have much impact on crude oil consumption for many years. The summary points below provide my rationale.

Range Limitations - Today, the vehicle with the longest range is the Tesla (NYSE: TSLA) Model S P100D which has a 65 mph cruising range of about 300 miles but costs over $130,000. The entry level Model S has a range of only 215 miles with a starting price of $85,000. These prices are well beyond the reach of most people. There are several affordable EVs today are available with roughly a driving range less than 100 miles making them suitable for most commuting duties. The Chevrolet Bolt promises both a reasonable price ($37,500) and a reasonable range of 238 miles but it is not available just yet. The way I look at today's EV offerings (and soon to be offered), even a 238 mile range makes the vehicle only useful for commuting to work and jaunts into the neighboring state. It won't get you very far on vacation or trips to grandma's house up north. While some families might opt for an EV as a second car, the current range limitations and inability to recharge quickly and conveniently (covered below) limits the usefulness of the current crop of EVs. Note that EVs carrying a heavy load or towing a trailer will have significantly lower range limits.

Recharge Time- Today, Tesla has the skeleton of a supercharger network but it is mostly concentrated on the east and west coasts. The interior of the country is sparsely covered with some states having only one or two supercharger locations and North Dakota, Nebraska, and Arkansas having none. The fact that this makes trip planning difficult is an understatement. This may eventually be overcome with a higher density of supercharger stations. What cannot be overcome is the time required to recharge the vehicle battery pack. With an internal combustion engine (ICE) car, you can find a gas station almost anywhere in the US, fill up the tank, and be back on the road in about 15 min including waiting on a couple of traffic lights. Tesla has the current state of the art in recharge capability but that current state of the art is still relatively slow. A Model S or X requires 75 minutes on the supercharger fully recharge the battery pack. Add in the time it takes to get off the highway and get plugged in and you are looking at 85 to 90 minutes for a full tank (charge). It takes us about 7.5 hours to drive to drive the 410 miles up to Pittsburgh to visit the relatives. That same trip in a high end Tesla would take up to 9 hours making one stop for a recharge. The state of the art is still very inconvenient.

Lack of Generation and Distribution Capacity - Electricity is not free and it has to be reliably generated to be able to power our homes and industry. We also need to maintain a reserve generating capacity to handle heat waves and unplanned storm outages. We've all seen the summer peak demand result in power company requests to limit air conditioning usage or turn off unused lights. In some areas of the country, we don't have much in the way of reserve capacity or the transmission and distribution system to deliver more power. Today, we don't have the generation capacity to displace a significant amount of gasoline or diesel used for transportation. Example: In 2015, there was a total of 3.06 trillion vehicle miles traveled in the US. A Toyota Rav4 EV uses about 45 kwh per 100 miles traveled. So, (3.06 trillion mi/yr) x (45 kwh/100 mi) x (1 yr/8760 h) = 157 million kw or 157,000 MW needed to replace all transportation miles in the US. A typical modern coal fired plant or nuclear generating station generates about 1200 MW of electricity. To replace all current transportation miles driven with RAV4 EV miles, would require up to 131 new large electrical generating plants in the US (157,000 MW/1200 MW/Plant). Even replacing 20% of the current miles driven in the US with RAV4 EV miles would require the equivalent of 26 new large generation facilities. This estimate is probably higher than that which would actually be required because some of the EV charging would occur during off peak hours when there is some spare generation capacity. But, you get the idea. We would have to build more generating and transmission & distribution infrastructure in order to support any significant shift from ICE powered vehicles to EVs.

I'm sure that I've not completely covered all the challenges to widespread EV usage but I think I've covered enough to make the point that we are still quite a few years away from widespread or universal EV adoption.

Where to Invest for a Resurgence in Crude Prices?

If this were a short term price correction, the answer to the above question would be easy. But, this latest crude price crash has been deeper and longer than most. Many of the super majors are sitting with weakened balance sheets and are taking on additional debt to continue funding their dividend distributions. Many of the smaller E&P companies are teetering on the edge of solvency and several have already filed. There will likely be a few more quarters of weak revenues and earnings for the E&P companies including the super majors. Given that background, the investments I'm targeting for a resurgence in crude pricing are summarized below.

Funds- I've owned the Vanguard Energy Fund (NYSE: VGENX) in the past and I'll be investing some of my qualified retirement funds to work in VGENX again. If you prefer an ETF, the Vanguard Energy ETF (NYSE: VDE) is a good option. Vanguard has some of the lowest management fees in the industry and a large fund gives you good diversification within the sector. Diversification is one way to mitigate the risk of any one company having a financial meltdown. I do favor Vanguard funds but there are other equally good funds available that specialize in the energy sector.

E&P Companies - Because this crude price crash has been so deep and long, I'd stick with quality companies that have solid balance sheets. Exxon Mobil (NYSE: XOM), Royal Dutch Shell (NYSE:RDS.B), and Total SA (NYSE: TOT) out of the super majors are my choice. I'm also looking hard at three small companies with their focus in the Permian Basin. Callon Energy (NYSE: CPE), Parsley Energy (NYSE: PE), and Diamondback Energy (NASDAQ: FANG). All three of these companies are small (under $7B market capitalization), somewhat speculative, but have the potential to be highly profitable when crude prices rise. I won't be putting a lot of money into these smaller companies but the potential upside warrants a small position.

MLPs- For those investors who don't mind dealing with the K-1 forms, there are a couple of solid midstream MLP companies that will have an oversized benefit from a recovery of crude prices. My first choice is Enterprise Product Partners (NYSE: EPD). The company has a very strong balance sheet and an experienced conservative management team. My second choice is Plains All American (NYSE: PAA). Almost as strong and competent as EPD, PAA was beaten down pretty hard in this oil price rout and they should have a equally oversized recovery along with crude prices.

Conclusion

Crude oil consumption growth remains robust. Continued vehicle sales growth in emerging markets, continued high sales of light trucks and SUVs in the US, increases in vehicle miles driven, and decreasing sales adjusted CAFE mileage in the US appear to me to be positives for continued growth in crude oil consumption. On the production side, the large reductions in capex budgets over the last two years, will ultimately have a negative effect on future crude oil production. I expect crude oil consumption and production to come to balance late 2016 or early 2017 and crude prices to rise. The price recovery could be quick and significant if consumption runs out ahead of production. Given the lack of investment in future production, I believe it is a matter of when not if crude prices will rise.

There are many ways to capitalize on the opportunity of rising crude oil prices. I've offered a few of my favorites. I'll be interested to hear other ideas from the Seeking Alpha membership.

Disclaimer: This article is intended to provide my opinion to interested readers and to serve as a vehicle to generate informed discussion in the comment posting. I have no knowledge of individual investor circumstances, goals, portfolio concentration or diversification. Readers are strongly encouraged to complete their own due diligence on any stock, bond, fund or other investment mentioned in this article before investing.

Disclosure: I am/we are long VGENX, FANG, EPD, PAA.

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.