If Only These 2 Things Come To Pass, Oil Prices Will Rise

| About: The United (USO)

Summary

Slowing economic growth has reduced energy demand growth, but the absolute numbers remain strong.

This will change as greener technology spreads, but very slowly.

Even bankruptcies won't stop the price leak.

Will oil prices recover as Wall Street presumes? That depends on the balance of supply and demand.

Climate change agreements notwithstanding, the world still burns, and will go on burning, a lot of fossil fuel. Slowing economic growth has reduced energy demand growth, but the absolute numbers remain strong. This will change as greener technology spreads, but very slowly.

The real mystery is on the supply side.

We know OPEC is trying to agree on production quotas. They will meet this month to make a final decision. I'm not optimistic that they can reach a deal, and I have no illusions that they can enforce any deal they might reach. The vast majority of OPEC members will cheat.

There's also non-OPEC Russia to consider. Putin is in no position to reduce cash flow right now. The situation is further complicated by the fact that the US shale industry is the pivot point now, filling the role formerly held by Saudi Arabia.

Our companies can dial production up and down quickly too.

Even bankruptcies won't stop the price leak

Many observers thought the shale industry would fall, as many debt-laden companies went belly-up. It hasn't turned out that way.

This October 24 Wall Street Journal headline tells the story:

It appears that even bankruptcy can't make these companies turn off the pumps. From the WSJ:

Energy investors have long hoped that falling prices would solve themselves by driving producers into bankruptcy and stanching the flood of excess supply. It turns out that while bankruptcy filings are up, they have barely impacted fossil-fuel markets.

About 70 US oil and gas companies filed for bankruptcy in 2015 and 2016. They now produce the equivalent of about 1 million barrels a day, about the same as before they declared bankruptcy, according to Wood Mackenzie. That represents about 5% of US oil-and-gas output.

That resilience has kept energy inventories flush and prices capped. Oil shot to $50 a barrel this summer, but has had trouble making much progress beyond that mark.

This is exactly the way Chapter 11 was meant to work. The process is designed to save companies that can be saved. And many energy companies are using it to lighten their heavy debt loads, adapt to lean times and keep producing.

I believe what's happening here is that people are forgetting the concept of "sunk cost." If you've already spent the money to locate oil and drill into it, pumping it out is not expensive.

Your creditors will want you to do exactly that too so you can stay current on your payments. Go bankrupt and the court-appointed trustee will order you to pump.

There is profit even at $40

In addition, the new technologies I described last year (see "Riding the Energy Wave") are making it profitable to drill and produce oil at ever-lower prices. The result is that more production comes on-line every time prices rise to $50 or so. That seems to be the cap on WTI crude, at least for now.

There are companies in the Permian basin that can reliably lift oil out of the ground and make a profit at $40 a barrel, and I am told the same thing is happening in North Dakota's Bakken.

The last I read, the Permian Basin in West Texas had produced some 50 billion barrels since oil was first struck in West Texas in 1920. The naysayers were talking about running out of oil in West Texas in the '70s.

Present estimates are that there are another 50 billion barrels of recoverable oil in and around the Permian. And it is getting cheaper every quarter to produce that oil.

These two things are required to get oil prices to rise

We need to see some sustained combination of higher demand and/or lower supply. Wall Street's 2017 earnings forecast is not going to come true unless crude can punch its way higher, to the mid-$50s, and stay there.

We haven't talked about currencies, either. The strong dollar has been cutting into the revenues of US multinationals. Many analysts think the dollar will change directions next year too, and that shows up in their earnings projections.

I'm the first to admit the greenback looks a tad overbought, but think about the competition. What other currency will get more attractive than the USD in the next year? The euro? Sterling? Yen? All the other major currencies have their own problems, far greater than the dollar's.

Yes, the US could well enter recession next year, and the Fed might cut rates even into negative territory. But currency values are relative. The dollar may weaken, but everything else will weaken even more.

One additional point: Investors are moving in a herd from active management to passive management, moving literally hundreds of billions of dollars into passive funds. Sometimes they do ring a bell.

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. I have no business relationship with any company whose stock is mentioned in this article.