Crude Oil - Pain In The Short Term, But Gain In The Long Term

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Includes: USL, USO, XLE
by: Rakesh Upadhyay

Summary

There are no signs of a slowdown in demand; even China's imports of crude oil have increased in 2015.

The supply from the U.S. is likely to decline in 2016.

OPEC countries are straining their economies due to lower crude oil prices. They can't continue at the same pace and will likely resort to a production cut soon.

The price of crude oil is threatening to break the low it made in 2009 during the Great Recession. Goldman is calling for $20/barrel, even though it attributes only a 20% probability to this trade. Big brokerage firms sometimes give outlandish targets -- remember the $200/barrel oil target given by Goldman a few years back. Most calls by the large brokerage firms must be taken with a grain of salt.

Commodity prices in the long term are determined by the balance between supply and demand. Before investing, it is important to understand the causes for this current bear market in crude oil. Here we shall ascertain if this is a temporary blip, offering a buying opportunity with large profit potential, or a permanent change for the long term.

Understanding Demand and Production Capacities

The chart above shows a considerable slowdown in demand (YoY) during the Great Recession. This led to a drop in the crude oil price from a high of $146.73 in July 2008 to a low of $32.7 in January 2009. The current bear market in crude oil exists despite a continuous rise in demand worldwide and a much better economic situation compared to the financial crisis of 2007-08.

According to the EIA, consumption of petroleum and other liquids was 1.2 million barrels/day in 2014 and is projected to rise to 1.4 million barrels/day both in 2015 and 2016. With prices remaining low, demand can surprise on the upside in 2016. The perceived slowdown in China isn't reducing their demand for crude oil. According to oil consultancy FGE, China's crude imports are likely to rise above 9% compared to last year.

The first point supporting a bullish case for crude oil is an increase in demand in 2016. The world needs more crude oil.

Production and Excess Capacity of Crude Oil

The supply of crude oil is another important factor that affects its price. A study of the current and the future supply possibilities will provide us with a clear picture about the next move in crude oil.

The above chart clearly indicates the surplus in production since 2014. Supply has outpaced demand by a wide margin in 2015. Going by the projections, this gap will be closed in the coming year. This excess supply outpacing demand justifies the current fall in crude oil prices. Let's now analyze if production is going to remain at elevated levels in the near future, or are there certain other factors that can affect production.

Shift in the Market Share of Major Producers

OPEC, led by Saudi Arabia, has been the deciding factor in controlling the price of crude oil for a long time. For the first time in years, the situation seems to be changing. The reason for this change is the spurt in shale oil drilling in the U.S. The growth in production by the U.S. in the last decade has been phenomenal, as can be seen in the chart above. Though all the countries have increased their production capacities, the U.S. has outperformed the others by a big margin.

Breakeven Price of Crude Oil Production

A drop in price normally leads to a cut in production in order to support it. However, this time, there is a power struggle between Saudi Arabia and the U.S. shale oil producers. The breakeven prices of the top three crude oil producing nations are shown in the chart below.

It was earlier estimated that the breakeven for shale oil production was closer to $60-$70 per barrel. The OPEC nations and Russia continued pumping oil and tried putting the shale oil drillers out of business. However, they haven't been successful because with new technologies, the cost of shale oil production in some regions is even lower than the current price.

According to a Bloomberg analysis, the cost of production of the Bakken Shale is around $29 and slightly higher in the neighboring regions. Another factor that supported the shale oil producers was that most of them had hedged their production at high prices -- some hedges were as high as $90/barrel. Most of these hedges are expected to end in 2015, after which a few drillers in the U.S. might struggle.

Russia and OPEC Nations Are Struggling Due to Low Oil Prices

The OPEC nations and Russia are heavily dependent on crude oil revenues to fund their respective federal budgets. A fiscal breakeven price chart for the OPEC nations and Russia is shown below.

It's clear from the chart that none of the countries of OPEC nor Russia can sustain pumping oil at current prices for long. Even additional supply from Iran might not change the situation materially. They might burn their reserves and continue for some time, but sooner rather than later the weaker nations will have to pressure OPEC to cut production.

Adverse Effects of Falling Crude Oil Prices on the Geopolitical Balance of the World

Though Saudi Arabia has strong foreign reserves, it's burning them fast. Its net foreign assets were at $654.5 billion in September 2015, the lowest number since February 2013. At current prices, it will be difficult even for the leader of OPEC to continue pumping oil for long.

Helima Croft, global head of commodity strategy at Royal Bank of Canada, has reported a possible power struggle in the Kingdom of Saudi Arabia. In an event of instability or a regime change in Saudi Arabia, the oil market will be severely impacted. During the Arab Spring, which started on Dec. 18, 2010, rulers were overthrown in Tunisia, Egypt, Libya, and Yemen. A few populist measures were taken by the neighboring rulers for the benefit of the people, but with crude oil prices remaining low, the Arab nations might find it difficult to fund these populist measures -- possibly leading to similar protests in the future.

According to Moody's, 75% of Russian exports and 25% of its GDP are linked to the energy industry. Lower oil prices are adding to the pain from existing economic sanctions by the U.S. and the Europe. With no investments foreseen in new wells, Russia might find it difficult to add to its existing production.

The Russian Economy ministry has declared that the capital outflow in 2015 is likely to be $90 billion, last year was a record outflow of $150 billion. In the current scenario, it is expected that President Putin might initiate geopolitical tensions to turn the attention away from his ailing economy.

Unsustainability at Current Prices Another Indication Why Crude Oil Is Set to Rise; Reduction in Investments Will Cause a Slowdown

Major oil companies are resorting to cost cutting and are cutting jobs across the sector. According to Wood Mackenzie, along with the job cuts, they have also delayed or cancelled projects worth $200 billion since 2014. Reduced investments and delays in projects will delay additional supply in the future.

The U.S. oil rig count has dropped 66% from 1609 in October 2014 to 545 in December 2015. Oil producers are not optimistic about the future and are resorting to cost cutting, which is the cause of the drop in the number of oil rigs. Though shale oil production has remained resilient, 2016 will be even more challenging if prices don't recover.

Which Instrument to Choose to Invest In

With all the above arguments, it is established that even though there is a surplus supply of crude oil at present, it's highly unlikely to remain for long. Major producers will have to cut back production, causing a supply glut, which is favorable for an increase in price. The next question that needs to be addressed is which instrument to choose to benefit from this trade.

Investing directly in crude oil futures might not be possible for many because of the volatility and the expertise required to invest in them. ETFs and stocks are a better option to reign in the benefit and still remain partially shielded from the day-to-day volatility. We will analyze three popular ETFs available -- United States Oil Fund (NYSEARCA:USO), United States 12-Month Oil Fund (NYSEARCA:USL), and the Energy Select Sector SPDR ETF (NYSEARCA:XLE) -- vs. the price of crude oil.

When comparing the three ETFs with the price of oil in the above chart, a few things become clear:

  1. USO is the worst among the lot because it underperforms on the way up and falls more on the way down. This is the worst possible combination.
  2. USL is more stable and follows crude oil prices both on the way up and all the way down.
  3. XLE has an interesting chart. In 2009, when the market was struggling, it was hit hard on the way down. When the stock markets recovered it took some time to catch up, and once the bull phase returned it came out as a clear winner. It is comparatively more resilient than the others in this downtrend. The only risk with XLE is, in case the stock markets crash, it might be slow to rise even if crude oil prices recover.

Reasons to Choose XLE

The main reasons investors should opt for XLE to play the up move in the crude oil market are:

  1. With all the central banks trying to put a floor beneath the markets, we might see a meaningful correction, but not a crash, in the stock market.
  2. XLE pays a dividend, and any extra income is always welcome.
  3. If the crude oil and the stock markets recover and enter a bull phase, history suggests that XLE has the ability to outperform the price of crude as well. This is our best-case scenario.
  4. It has lowest expense ratio at 0.15% among all the three.
  5. The only risk to our choice of XLE is if crude oil doesn't recover, and the stock markets crash, XLE is likely to be the worst performer among the three. The probability of such a scenario is rare; hence, we advise a buy on XLE.

Conclusion

The data above shows that though the production is outpacing demand in the short term, it's unlikely that the producers can continue pumping oil at such low prices without negatively impacting their economies. Low crude oil prices are not desirable for most of the developed nations who are struggling to ward off deflation. Due to lower investments, any fresh addition to production is likely to be on hold, and cannot start quickly to satisfy the rising demand in future. It's only a matter of time before crude oil prices bottom out and start their uptrend.

At current price, the risk/reward on crude oil is very attractive. As it's difficult to predict the exact bottom, investors should start investing in a staggered manner to reduce their risk. A smart investor should analyze the future and stick to his or her investment principles in the wake of temporary near-term negatives. We expect that crude oil is close to a bottom and, as such, recommend a buy on XLE at 63 for the long term.

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.