Oil - Will There Be More Blood?

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Includes: CHK, CLR, EOG, USO
by: Timberwolf Equity Research

Summary

Oil prices have been in decline for roughly 18 months now and have lost roughly two-thirds of their value.

We have not seen oil prices below $30 in more than a decade; questionable whether this price can sustain US shale producers.

Taking a closer at the drivers behind the reversal of high oil prices reveals some interesting trends.

What are the determining factors in the future direction of oil prices?

Oil 2016 A lot of the volatility currently experienced by stock markets globally seems related, at least in part, to the almost continuous decline of oil prices (NYSEARCA:USO) that started roughly midway through 2014. Intimately related to concerns over low oil prices is the fear that the Chinese economy is slowing down much quicker than expected. After all, weak demand from China can have a large impact of global commodities markets, including crude oil, as we have already seen in things as diverse as iron ore or milk powder. These fears spring from the idea that weak oil prices are caused by slower economic growth, which of course would be detrimental to equity values.

The oil price collapse as evidenced by the price chart of the February 2016 NYMEX Crude Oil Future.

However, the supply side of oil has also been mentioned as a major factor in oil price declines, with surging US shale oil production often mentioned as the most important culprit on this side. So, what are the dynamics driving the decline in oil prices? In this article I will take a closer look at the supply situation, the demand side and how they interact.

Gaining more insight may will help us decide whether the beaten down oil and gas sector has become attractive bargain hunting ground. It certainly can be if oil prices bounce back, but it probably will not be if oil prices stay depressed. In my opinion, we need a well-researched outlook on oil prices before considering sector investments.

Going to the Source: Supply-Side Changes

The supply side of oil has drawn my interest for over a decade when, starting around 2005, I became convinced that peak oil was a real threat. I read books my Kenneth Deffeyes and Matt Simmons detailing how at one point the supply side of crude oil would reach maximum output and go into an irreversible decline after. Ken Deffeyes at one time worked with M. King Hubbert, who is widely seen as the father of peak oil theory ever since his claim that US oil production would reach a peak in the early 1970s appeared more accurate with each passing year. US oil production went into a steady decline after the early 1970s with only a brief revival in the early 1980s when production in Alaska's Prudhoe Bay oilfield was ramped up. This decline in US production caused an increasingly large domestic supply shortfall, which was offset by rising imports of foreign oil, which for much of the 1980s and 1990s was relatively inexpensive. During the 2000 era that changed and peak oil theory was revived in a major way with the publication of such works as 'Twilight in the Desert', in which Simmons claimed that world oil production would peak when Saudi Arabia's elephant Ghawar field reached its highest point of production. Despite a lot of volatility, oil prices did appear to move decidedly upward until 2014, with some particularly volatile movements during 2008 and 2009.

But in a move that perhaps was foretold by natural gas prices, oil prices declined quite violently during H2 of 2014 and have been in a bear market ever since. Oil below $30 is something we have not seen since 2004. In order to understand this unexpected collapse I have taken a look at some data, which I have shared through the graphs below. In the first graph, I have compiled oil production numbers for the world's largest producing countries (since 2002), which are those producers with daily production of over 2 million barrels. The green line reflecting US production immediately catches the eye when looking at this chart.

Graph above is the author's own work using data gathered by Jodi Oil World Database, which is a data-sharing organization founded by some of the most important energy institutions in the world, like the EIA and OPEC. The graph shows oil production volumes for the world's thirteen largest producers between January of 2002 and October of 2015.

The world's two largest producers are Saudi Arabia and Russia, which have both succeeded in meaningfully growing their output since 2002. Saudi Arabia's self-proclaimed position as a swing producer is very visible in its line (upper blue), which shows larger fluctuations than the production lines of the other countries. As you can see, Saudi Arabia has recently decided not to decrease their production in the face of higher global output but appears to have spent much of 2015 pumping more oil instead of less. That decision constitutes a major policy reversal by the Saudis, which has been attributed to their intention to drive oil shale producers out of business (Saudi oil is widely understood to have a very low cost of production). Whether this strategy will work seems questionable given the fact that US producers have access to relatively cheap credit, which may allow them to survive for a much longer time than during the 1980s (when the Saudis tried the same trick).

Most countries with daily production between two and four million barrels have generally succeeded in slowly increasing production, although production in Venezuela and Mexico has declined over the last decade. More importantly, important producers like Iran and Iraq have been held back by adverse circumstances like war (Iraq) and trade embargoes (Iran), which has led to underinvestment in their oil and gas infrastructures. Both countries are widely assumed capable of significantly higher production given adequate levels of investment. Now that the Western trade embargo against Iran has (virtually) ended, it is not so much a question whether Iranian oil production will increase but rather by how much and how soon. Iran has said they will instantly increase production by as much as half a million barrels per day, which is slightly over 0.5% of global consumption. This may not seem like much but in the current situation of oversupply this may put increasing pressure on already weak prices.

US shale revolution

The green line showing a strong upward trend resembles crude oil production in the United States. This change in US production is a phenomenal development in every sense of the word; it has been caused by the ultimately successful attempt to tap crude oil from shale reservoirs, which for many decades appeared to be impossible. This constitutes a real revolution in oil production because it was made possible by the rise of new technologies like horizontal drilling, multi-stage hydraulic fracturing and 3D seismic imaging. Books like The Frackers by Gregory Zuckerman and The Boom by Russell Gold detail how this revolution was preceded by many years of trial and error by companies controlled by independent oilmen like George Mitchell and Harold Hamm of Continental Resources (NYSE:CLR). During the latter years of the 2000s, their companies and others like them, including Chesapeake (NYSE:CHK), XTO and EOG (NYSE:EOG) started to see increasing gas production from reservoirs that had been declared impossible to tap by the industry majors, later followed by oil.

The natural gas markets were disrupted by these same technologies a couple years earlier, which perhaps should have been a clear indication that the oil market would undergo similar changes as well. The truth is that not very many people foresaw what happened in the oil market, even if with perfect hindsight it may appear to have been unavoidable. In the graph below I have put the production increase in historic perspective, detailing US oil production from 1920 until now. The enormous surge in production from 2011 on has brought production in the US back to levels last seen in the 1970s. The steep rise in volumes in the past years corroborates the notion that a true industry revolution has taken place. After all, the natural rates of decline in producing wells means that oil production is highly dependent on offsetting these declines by drilling new wells. For almost four decades the US oil and gas industry failed to offset declining rates of production in existing fields by new production.

The graph above is the author's own work and represents US crude oil production since 1920. Data obtained from the Energy Information Administration. Please note that the graph displays monthly data; 300 million barrels per month or roughly 10 million barrels per day.

Moving Downstream: Demand Changes

Of course, rising production may not have any effect on prices if demand is going up at the same rate. But the developed economies of the world have generally gotten more energy efficient over the past decade, which may be a result of the relatively high price levels seen in oil. The United States is no exception to this rule, as can be seen in the graph below. The United States currently uses around 19 million barrels of crude oil per day, which is an awful lot (almost one-fifth of global usage), but its demand has been more or less stable over the past two decades. Demand steadily increased every year between 1990 and 2006 but has only partially recovered the demand lost since the economic crisis of 2008. This may be due to any number of reasons but seems likely to be a result of several factors, including high relative prices, replacement by natural gas and an accelerating shift towards renewables. More efficient cars are probably also part of the explanation.

The graph above illustrates the volumes of US oil products supplied and is the author's own work using data from the EIA.

Surging domestic production combined with relatively stagnant domestic demand means the United States is quickly decreasing the amount of oil products it imports. Still, as can be seen in the graph below US oil imports still constitute roughly half of its total demand for oil. Imports (blue line) have decreased (almost) every year since 2006, presumably as a result of the economic crisis at first, but in more recent years as a result of surging domestic supplies as well. This has allowed the US to become less dependent on countries with which its relationship has been rocky in the past, including large producers like Russia, Saudi Arabia, Venezuela and Iraq. The only major producer which has seen its exports to the United States increase is Canada (this includes refined products), as indicated by the rising red line.

Graph above is the author's own work and illustrates US oil product imports in total and separately by country of origin. Data obtained from the Energy Information Agency. Please note that volumes are on a monthly basis.

Graph below details US oil (product) imports and exports in barrels per day. Graph is the author's own work using data from the EIA.

The changes in the domestic supply and demand balance have even stimulated strong growth in oil product exports, as can be seen in the graph above. US imports of oil products are down quite strongly but net imports are down even more, as US oil product exports roughly quadrupled over the past decade. This may be the result of price spreads between the US and other markets, which gave the US some advantages in refining. For instance, the oil grade known as WTI (West Texas Intermediate) used to trade at a premium to Brent crude, which is a North Sea grade that is less light and less sweet. Presumably this was because WTI has qualities that make it easier to refine, but in recent years these grades have traded at an inverted spread. As can be seen in the graph below, the price gap between these two grades increasingly widened in favor of Brent (blue line), which in my opinion was due to supply side changes in the US. In recent months, this gap narrowed considerably and then all but disappeared, which seems to indicate that the global supply and demand situation has relaxed as well.

Graph from Marketwatch displaying the relative price trends for Brent Crude (NASDAQ:BLUE) and WTI (brown) since 2011.

Decreasing US imports since 2006 have not resulted earlier oil price declines because other countries were increasing their imports. In the graph below, I have gathered some data on the ten largest oil importers in the world. As can be expected, declining US imports, which went from 10 million barrels daily to less than 8 million, were offset by strong demand growth from China, which went from roughly 3 million barrels in daily imports to well over 6 million in the same period. What is quite striking is that developed economies like Japan, Germany, France, Spain, Italy and the Netherlands also saw declines or stagnation over the past decade. Needless to say, some of these countries have seen a good deal of economic struggles but it also seems to indicate their economies are becoming more fuel efficient (just like we saw in the US). Other developing economies like Korea and India meanwhile saw their imports go up, although less quickly than China.

Graph above is the author's own work using data gathered by Jodi Oil World Database. The graph shows oil import volumes for the world's ten largest importers between January of 2002 and October of 2015.

Oil Outlook

There are several important variables determining the future direction of oil prices. The first one is whether large supply side changes will result from the current low price level. There has been a lot of discussion about the cost of production for US shale oil and how much its producers are suffering right now. Current prices are not the only factor in shale production however; normally, oil producers have locked in prices for significant parts of their production through futures. This means they may be getting $60 or $70 a barrel for oil they are currently producing. Depending on how much and how far into the future their prices are locked in will be an important factor influencing future US shale production. Other relevant factors are oil and gas debt maturities, industry access to financing, lease terms etc. Some companies may pump oil below cost just to produce some cash flows while others may drill just to keep their leases. Harold Hamm of Continental Resources has been very active in predicting oil price rebounds; the problem with insider's opinions is that these people have a huge interest in seeing higher oil prices, which may mean they are talking their own book.

Global factors that will determine prices are the oil policies employed by Saudi Arabia and other producers like Russia. In the past, OPEC often tried to limit the amount of global supplies by negotiating production ceilings for its members. The problem with this strategy is that OPEC members cheated each other by secretly pumping more oil than allowed, which oftentimes meant Saudi Arabia was more or less forced into the position of swing producer. The other two mega-producers, Russia and the United States, are not in OPEC but the former may be open to reducing production if it believes lower output will improve prices. Both Saudi Arabia and Russia are being hurt enormously by the currently depressed price levels, which may at some point drive them the negotiating table.

Demand from China is a third important factor that will determine prices, given that it has become the fastest growing net importer by far and may surpass the United States as the largest net importer within a couple of years. Global oil demand growth therefore will be driven to an important extent by the expansion of China's economy.

I expect that US shale production will decline if current prices persist, which is a conclusion that naturally follows from the reports sharply lower rig counts. Oil at current prices seems too cheap to unlock significant new production, which means that the situation of oversupply should ease over time. The question remains whether lower US production will lead to a reversal of the global situation of oversupply and how quickly and sharply oil prices will rebound.

In my opinion, that is a much more difficult question to answer given the unpredictability of oil politics in countries like Saudi Arabia and Russia. In my opinion, we are very unlikely to see $100 oil in the near future, especially if we consider the fact that the shale technologies pioneered in the US can be copied by operators in other countries, including countries like China. I assume it is natural for the Chinese to have a strong interest in domestic shale production given their increasing dependence on foreign sources for what still is a strategically important commodity. Giving the economic slowdown in China and the reemergence of Iran in the global trade system, I am not counting on significantly higher oil prices in 2016.

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.