Source: Stock Photo
The new bullish narrative for oil is that there will be an oil supply shortage in the near future, which will lend support to the price of oil while pushing it up significantly. I agree with Exxon Mobil (NYSE:XOM) CEO Rex Tillerson when talking to the Oil & Money conference, that there is plenty of global supply that will keep that from happening over the next 3 to 5 years.
"I don't necessarily have the view that we are setting ourselves up for a big crunch within the next 3, 4, 5 years," said Tillerson.
What drives this outcome according to a number of analysts and pundits is the idea a number of oil producers have cut back on investment, which will result in a shortage in the years ahead. The problem with that assessment is it doesn't take into account the tremendous advances oil producers have made in identifying the best locations, technology and methodology, which has brought a huge increase in productivity, which in turn has lowered costs.
The U.S. shale industry in particular can now produce much more oil at a lower cost than a couple of years ago, which means when they add rigs and complete wells, the amount of oil brought to market is far more than in the recent past. This is why the old way of looking at the industry no longer applies. There isn't the need to invest capital in the way it was in the past to achieve the desired results. A lot less capital can bring superior output than before.
The market continues to discount the disruption coming from the U.S. shale oil industry. That will continue to surprise to the upside as the current scenario of OPEC asserting there will be a production cut, and the effect that will have if it is implemented over the next 6 months and more, as shale producers continue to add rigs and complete wells.
Tillerson see plenty of development of oil resources at this time, and rejects the idea of a global supply shortage because of the perceived lack of investment in new projects.
It's also certain over the next several years we'll enter into a recession, which will have a significant impact on demand for oil. That means even more oversupply during the next 5 years or so.
My thought is after this initial boost in the price of oil because of the proposed OPEC cut fades away, oil will once again fall into the $40 to $45 range. It may take a few months to do so, but the fundamentals are still in place for a prolonged period of oversupply, even if there is a weak cut from OPEC.
Technology and oil
I think Tillerson must be reading my articles because I've been consistently adamant that the U.S. shale industry still is misunderstood as to how deeply it has disrupted the oil sector.
In a short two years the advancement in technology and improved methods of identifying the best locations and working them, has significantly lowered the cost of shale producers while increasing productivity per rigs and wells.
This is evident in the nonsensical response to an OPEC production cut, where the idea OPEC can do the same things it has done in the past and achieve the same results, even though the emerging U.S. shale industry has already shown it can't work. That isn't to say the media blitz coming from OPEC and those in the oil sector won't temporarily support the price of oil, but it does mean oil investors need to beware because this is becoming bullish beyond justification as will be found out in the months ahead.
Improved technology and methodology in the shale industry will offset lower capital investment and the silly production cut being proposed from OPEC.
Again, there isn't a need by shale producers to spend the same as in the past to achieve even better results. It's only a matter of how long it takes them to transition to the bulk of their well portfolios being premium wells. Now it's a mixed bag, which is why we're not seeing the supply coming to market we'll see over the next 18 months.
For these reasons there will be no price surge in oil over the next several years, as some old school analysts are asserting. They apparently haven't received the memo about the long-term disruptive force that is the U.S. shale industry.
Tillerson and Exxon
The question is why Tillerson is so strong and clear concerning his message. I believe it's because he sees where the oil industry is visibly going, and is tempering shareholder and investor expectations for the next several years.
It could be concluded that he could be pushing shareholders to think of a possible reduction in its dividend, but at this time I don't think that's the case. More than likely this is primarily management of expectations, with any upside surprises a bonus for shareholders and the share price of the company.
What Tillerson appears to be saying is the oil market is probably going to continue on where it's currently at, with there being more risk to the downside than a move to the upside. Most of what can be priced in is already priced in. He apparently sees, as I do, shale production offsetting any OPEC cut or decline in capital expenditure for the reasons already mentioned.
This means in regard to Exxon, things are probably going to remain close to where they are today. That suggests to me, unless the recession totally crushes the pace of demand growth for oil, prices will be at best operating where they are today, with the strong probability they'll decline when oil demand underperforms as the global economy contracts.
While all the cheerleading is going on, Tillerson is rightly and responsibly telling Exxon shareholders the overly bullish sentiment isn't justified because it doesn't include the ongoing disruption coming from the U.S. shale industry. Acting as if they've been subdued by OPEC and the oil sector can now operate as it has done in the past is a bad idea to embrace. Shale producers have already proved they can grow in a low price oil environment. Why the idea of a production cut from OPEC will change that doesn't make any sense. If anything, it'll only strengthen the shale industry, not hurt it.
The idea some believe is OPEC has slowed down the shale industry enough to implement a cut in output without enduring the consequence of a loss of market share. Where the dice is being rolled by OPEC is in regard to whether or not the improvements in productivity will offset lower rig and well counts. We're going to find out over the next year whether that's the case. There is no doubt in my mind that shale producers will win this battle and prove to be the superior force in the oil industry.
Tillerson obviously also believes this, which is why he's making the comments he's making concerning his outlook for the oil sector over the next 3 to 5 years.
Global oil supply and demand
As for global supply and demand over the next several years, the idea of supply being overwhelmed by supply is a wrong one. A lot of that comes from the fact the next recession is going to cut into the pace of demand growth for oil, as is already being confirmed from slowing demand as a result of slowing economies.
Demand for oil has been downwardly revised to 1.2 million barrels per day in 2017, and this may prove to be too optimistic, depending on how quickly the economic slowdown takes hold.
As for supply, I see nothing to point to it not continuing to grow. The OPEC production cut isn't going to have the impact some believe. Shale producers are going to step into the vacuum and force OPEC or Russia to quickly ramp up production in response to that reality. It's only a matter of how long it'll take because of the current well mix that includes lower producing, older wells. As the well portfolio mix changes to more premium wells, the amount of supply coming from shale producers is going to soar.
We are currently in that transition period, which is why it's not clear when the inflexion point will happen. For that reason a production cut, in the short term, may provide temporary support to the price of oil from a possible decline in output, but it won't be able to hold long as shale oil floods the market.
The combination of robust supply and a slowing pace of demand growth ensure the price of oil isn't going to soar in the next few years, as some hope it will.
There are two basic things oil investors need to consider when analyzing the market. The first is shale producers have totally disrupted it. There will not be a return to the past way of doing business. This is why the proposed OPEC production cut, while a nice sound byte for the media, will have little in the way of real impact on the price of oil over time. It will in the short term, but it'll be completely irrelevant when shale producers increase the amount of premium wells as part of their overall portfolios.
Capital expenditure is one of those areas that must be re-evaluated because it doesn't take the same amount of spending to achieve even better results; it doesn't take as many rigs or as many wells to boost supply. This either isn't understood by the broad market, or it's being ignored for the time being. Either way, OPEC can enjoy its temporary moment in the sun, as it will become clear in the near future it is no longer the swing producer it was in the past, and U.S. shale producers are.
That doesn't mean the price of oil won't find support during this transitional stage, because it obviously already has. What it means is that over time, the OPEC cut will be found to be futile as shale producers flex their muscles and ramp up production at lower costs and higher productivity than they ever have.
Tillerson knows this and is guiding, in my opinion, shareholders to understand this scenario. Exxon is likely to continue to perform at similar levels over the next few years as it has over the last couple of years. That's the message being sent by Tillerson, and I believe he's right.
I don't see how anyone could draw the conclusion oil prices are going to spike in the years ahead.
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.