Why $75 Oil Will Be The Bottom

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Includes: BP, COP, CVX, EIA, EOG, GS, KMI, SDRL
by: Henry Stokman

Summary

Barron's original $75 oil prediction has almost come true, but it will only be short-lived and not long-term.

Oil's recent sell-off has more to do with market expectations and assumptions than fundamentals.

The current oil pricing has created a unique opportunity to purchase a lot of high quality oil companies at some very compelling prices.

I wrote an article back in April entitled 'Why Barron's is Wrong on $75 Oil'. The article highlighted why I felt Barron's was wrong on their prediction that oil would begin trading down toward $75 per barrel. Given that oil in the past 60 days has seen a precipitous decline all the way down to the $79.50 level, I thought it was appropriate that I revisit the topic.

In the original Barron's article there were three main reasons that the author felt were going to be the main drivers contributing to lower oil prices. The three main reasons were as follows: deep-water oil, shale oil, and oil sands. All of these newfound resources are estimated at roughly one trillion barrels in newfound oil. Adding that onto the existing global oil reserve estimated at 1.5 trillion, makes this newfound oil a major factor in the future of oil pricing. The article referenced Citigroup energy analyst Eric Lee, who believed that most of this new oil could be recovered for under $75 per barrel, leading to a global decrease in price.

Even though Barron's may have been correct on its pricing prediction, I don't believe that the root cause of the pricing is the same as what was highlighted in the original article. Instead I feel that there are three very different factors playing into the current price of oil.

  • Belief that there is a large oil inventory build resulting in an increase in supply
  • OPEC nations desire to see new U.S. hydraulic oil frackers go out of business
  • Market expectations around global growth and future oil demand, primarily in Europe and China

Oversupply Doubt

Oil supply and expectations of future oil supply no doubt have a major impact on the overall pricing of oil, but the Arab oil embargo act of the 1970s is indirectly causing a lot of this presumed supply build. The oil embargo act basically makes it illegal for the U.S. to export any oil, with some exceptions. The problem is that as the U.S. continues to drill and find oil, we really do not know what to do with it but store it, resulting in an increase in supply. Just this week, oil reserves increased by 2.1 million from the week prior, putting U.S. oil reserves at around 380 million barrels. This new supply number puts the U.S. oil supply toward the upper limit of our historical averages.

To keep things in perspective though, even with the current supply influx the existing oil reserves are still within a historical range and would not indicate to me that oil prices should be trading at current levels. Just last week, Goldman Sachs (NYSE:GS) analysts stated in a Bloomberg Businessweek article that they believe the recent oil sell-off has been overdone. The article highlights that Saudi Arabia should no longer be viewed as a main producer to balance the oil market, but instead it should be understood that U.S. shale oil production can be easily decreased or increased to bring balance back to the market. Additionally, the article states that for every 10% drop in the price of oil, consumption grows by 0.15%. With oil down over 30% since this summer, consumption has essentially increased by almost 500,000 barrels per day.

As price continues to come down to a point where drillers no longer see it valuable to drill and consumers continually demand more cheap oil/gas, it is only a matter of time before the macroeconomics of this begin to take control, pushing oil back up.

Saudi Arabia Factor

Another one of the main drivers for the recent decline in the price of oil is due to not just increases that have been seen in supply here in the United States, but also with increases in other oil producing countries, mainly Saudi Arabia. Since the oil selloff begin this past summer the country has kept its production levels quite high considering the current price of oil. Historically, Saudi Arabia has been known for its ability to quickly step in when prices begin to slide and cut production, resulting in a price stabilization. This time around, however, the country is not doing that.

Saudi Arabia is one of the larger OPEC countries that still have a fair amount of excess capacity. With the country being the largest of the OPEC nations, they continue to have quite a bit of influence on the price of oil and given its $500 billion in oil reserves, also has a vested interest in where the price ultimately goes. This can be seen earlier this month when the country adjusted its crude pricing without consulting its fellow OPEC members.

There are many theories out there as to why Saudi Arabia would be doing this, but one of the main theories currently is that the country is playing a game of cat and mouse with the United States' fracking industry. Knowing that a number of the hydraulic frackers need a much higher oil price to maintain margins and that several of the companies currently are heavily levered, Saudi Arabia is banking on the fact that these lowered oil prices will push them out of the market and will allow the country to regain its heavy influence on the global price of oil.

With all of this supply and price manipulation occurring the bigger question I have, is how long can Saudi Arabia continue with this stalemate, while not taking on any additional political pressures from fellow OPEC members? The undercutting that is currently occurring is what initially prompted the formation of the OPEC cartel, but lately it seems that member nations are just going back to doing whatever suits their countries' most immediate needs. Even if it means that fellow members' economies cannot support current prices.

Global Economics

Another large driver for the recent decline in oil price is traders believe that the global economy (specifically China and Europe) is really starting to slow down. This has no doubt fueled the current oil bear market. I no doubt believe that a slowdown in both Europe and China will/could play a factor in oil pricing in the short term, but I don't believe that a slow down there would warrant a 30% correction.

According to the U.S. Energy Information Admiration (EIA) China this year is expected to consume around 10.1 million barrels of oil per day. This is an increase of 3.5% from the country's consumption rate the year prior. Currently, global oil production averages around 90.33 million barrels per day, with global consumption currently at 90.38 million barrels per day. Assuming that China does experience a slowdown of say 20%, that would reduce its current consumption by about 2 million barrels per day, creating a worldwide excess capacity of about 2 million barrels per day. The excess capacity may bring the price down a bit, but I believe it would only be temporary.

The U.S. Energy Information Administration (EIA) expects worldwide consumption of petroleum products to grow by 1.2 million barrels per day by the end of 2014 and 1.5 million barrels per day by the end of 2015. This increased demand would put worldwide oil consumption at around 91.60 million barrels per day by the end of 2014 and 92.97 million barrels at the end of 2015. These increases in consumption would not only eat up any excess capacity that would be seen by a slowdown in China, but would put the world in an under-supplied situation resulting in much higher prices to meet the new demand.

Even with the three factors that I have outlined above playing such a large role in the current price of oil, I want to reiterate that I feel that the recent slide in oil is only temporary and that once this noise is gone we will once again begin to see oil back in the mid $90 to low $100 per barrel range. That range seems to be the range where oil production and consumption are most close to equilibrium. That is not to say that oil is done going lower. Quite frankly, I think oil could continue to go down into the mid $70s before this selloff is complete.

That being said, I would view this recent sell off as an excellent opportunity to pick up some heavily beaten down oil companies that have traded down indiscriminately with the price of oil. Given that oil and these companies could continue to experience some pain I would be buyer of larger integrated names and drillers that sport higher yields. Several of the names outlined below are paying very nice dividends at current levels and just as these names followed oil down, they should also follow it back up. Specifically, I like Chevron (NYSE:CVX), Conoco Phillips (NYSE:COP), Kinder Morgan (NYSE:KMI), SeaDrill (NYSE:SDRL), BP plc (NYSE:BP), EOG Resources (NYSE:EOG), and Transocean Ltd(NYSE:RIG).

Lastly, I must give credit to Barron's for calling the $75 oil price. Even if the direct causes of the price were not spot on, the fact that the price predictions occur and those that would have followed their call would have made a lot of money, I must give credit where credit is due. Having said that, I still don't believe that these prices are here to stay and would view the recent price action as a gift.

Disclosure: The author is long CVX, KMI, RIG, BP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.