3 Reasons Why Oil Price Is Undervalued

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Speeder

Summary

I think that everybody here at least once discussed the declining oil prices.

Many analysts say that oil prices can fall further in the future, but I do not really believe that.

Instead, I want to give you three reasons as to why oil prices should be about in the range of 50-70 $/bbl. levels.

Introduction

I think that the most widely discussed topic nowadays is oil. Diagram 1 shows that the current price level of Brent is at the lows of 2008. WTI is also trading nearly 2 times lower (Diagram 2).

Diagram 1. Brent price.

Source: FinViz.com

Diagram 2. WTI price.

Source: FinViz.com

The significant decline in oil price has been explained several times by reasons like the lowering of GDP growth in China, a crude oil oversupply (influenced by the shale oil expansion in the USA, which has made the country the world's top oil producer; see Diagram 3), the development of alternative sources of energy, and so on. The most popular topic right now is the possible impact of Iran's re-entry into the oil market. Analysts keep saying that the "Return of Iran's oil and a potential Grexit could pressure prices that are down 10% on month". It looks as though many people, in fact, believe that.

Diagram 3. World's Top Oil Producers

Source: CNN Money, EIA

In this article, I do not want to change one's mind about a possible further decline in oil price: I heard of forecasts of $20 per bbl for WTI. Moreover, a few rational explanations for that exist. However, I do want to name three main reasons why oil should remain at price levels of circa $60-70 per bbl in the long-term perspective.

Reason #1. China slows down, but remember about other countries

When reading the EIA Short-Term Energy Outlook (as of August 2015), I saw a nice illustration (Diagram 4), which shows the perspectives of oil production and consumption until Q2 2016. In spite of the fact that the agency projects a positive balance of world oil supply/demand, the growth of demand is also mentioned in the report. Demand should change from 93.62 mln.bbl/day to 95.08 mln.bbl/day, or by 1.66%. During the same time period, there is a forecast of growth of 0.44 mln.bbl/day (0.36%), totaling 96 mln.bbl/day. This forecast takes into account the effect of Iran's expansion (the agency estimates the effect of the increase to be about 0.3 mln bbl/day in 2016, on average). In fact, oil production will continue to outrun oil consumption. However, the demand for oil is expected to surpass oil supply in the long-run.

Diagram 4.

Source: EIA Short-Term Energy Outlook, August 2015

On the other hand, I think that the demand for oil will rise by more than what EIA estimates. Why? Well, other countries like the USA, India, and Japan will boost their consumption. There are two reasons for that.

The first one is that both the USA and Japan have seen a growth of investments as a percentage of GDP during the last 5 years. As we know from the example of China, the growth of investments always leads to industrial growth, while the main consequence of industrial growth is the increase in oil consumption. USA and Japan are the world's 1st and 3rd oil consuming countries. Consequently, there is a strong evidence of growth in absolute terms (in bbl/day). However, Japan's real GDP growth in 2014 left much to be desired. Nevertheless, I believe in the country's solid GDP growth in 2015 and 2016. OECD has the same opinion. India's investments have been low during the last 5 years, but in 2014, they again began to grow. India is the world's 4th leader in oil consumption (after Japan). Moreover, the country has a high perspective for population growth.

Diagram 5.

Source: IMF, infographics by author

Diagram 6.

Source: EIA, infographics by author

The second reason is that US car dealers always monitor the growth in sales of "petroleum-using cars" when oil prices go down. This year is not an exception. As the National Automobile Dealers Association says (redirect to US News), there were almost 17 million cars sold in 2014 (the best year for car sales since 2006). Moreover, they expect to sell not less than 16.94 million cars in 2015. According to this forecasts, the internal use of oil in US should rise significantly.

Reason #2. Costs of production are much higher nowadays than in the past.

The average marginal cost of oil production has been significantly rising over the last 30 years. Despite of the new technologies, it becomes more and more difficult to extract oil. Breakeven prices of Crude Oil are given in Diagram 7. Complex methods, such as tertiary drilling (see Diagram 8), and drilling from hard-to-reach area (such as Arctic drilling and Shale drilling) require more money on OpEx and CapEx. Consequently, it makes breakeven price rise significantly.

Diagram 7.

Source: Market Realist

Diagram 8.

Source: Market Realist

Today, most drilling methods cannot be used because oil prices are below the breakeven points. Hence, the supply of oil will fall, and oil price will increase in the nearest future.

Reason #3. Believe in alternatives but be a realist.

I really like Tesla and its business model. However, the world made from electric-battery cars in the nearest 10 years seems to be a fantastic dream for me. A world that does not use oil in manufacturing, chemical industry, and in utilities is a fantasy in the nearest 50 years. A world that does not use oil at all is impossible.

One of the reasons why the humanity has made a success in the 20th century is the exploration of new oil drills and the inventions of new methods to do that. Nowadays, the economies of more than 75% of the world's countries, in different ways, strongly depend on oil. In my opinion, oil has become a sturdy part of modern reality. That is why there are no reasons for crude oil to be in the $20 levels in the future.

Conclusion

I think there are even more reasons to justify higher oil prices than what I have mentioned above. In my opinion, the average oil price should be 15% above the world's median breakeven price because the 15% margin is the usual premium set by oil-exploring companies, both IOC and NOC. According to Diagram 7, this price is about 51 $/bbl. Consequently, the average prices for crude oil should be around 58.65 $/bbl. However, this price can fluctuate from 50 to 70 $bbl because of the distribution of market shares of different countries in the world's oil production. Nowadays, the oil price is below this range and it should rise back to these levels soon.

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.