Light At The End Of The Oil Price Tunnel

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Includes: OAS, PACD, WLL
by: James Hanshaw

Summary

In its attempt to damage others Saudi Arabia shot itself in the foot as well. Both its oil and financial reserves are going down rapidly.

The gap between world crude oil demand and supply is not great.

That gap will be bridged later this year and could be sooner if Saudi and others make modest production cuts.

Once bridged crude oil prices will rise rapidly and so will producer and service company share prices.

For around 18 months I have been watching the plunge in crude oil prices and with it my investments in US shale oil producers. When I bought into those I thought they would be a haven unaffected by the almost continuous internal and external conflicts that plague many other oil producing countries. That proved to be a reasonable judgement at first but it proved to be a disaster when the leader of those other countries - Saudi Arabia - declared an economic war on its main ally, the US, and on its partners in the OPEC cartel by not reducing production to match supply as it had in the past. I suspect it expected faster results and was not prepared for the damage to its own economy when it did not get them given the fact it has subsequently drained its financial reserves by over $100 billion to support a budget that requires $96 per barrel to break-even and it will have a further budget deficit of $87 billion this year according to Saudi's own statements on TV interviews. It has reduced its oil reserves too without replacement, as far as I know.

I have read reports on this in SA articles and in the Financial Times by people far more knowledgeable than I but have yet to see an easy to understand global view of where we stand today and I will attempt to do that here. I hope this can be confirmed and added to or countered by SA readers.

US industry expert T.Boone Pickens recently suggested that crude oil supply exceeds demand by 1 million barrels per day(mb/d). The London brokerage firm pvmoil.co.uk puts the figure at 1.5 mb/d. Figures from eia.gov suggest world consumption is around 93 mb/d. Taking the higher figure of 1.5 mb/d means supply exceeds demand by 1.6%. That is not a huge difference but cumulatively it is - nearly 550 million barrels per year of excess crude. Estimates of oil now stored in tankers and onshore around the world support that excess production number.

That paints a gloomy picture but IF, and it is a big IF, the main oil producing nations were to agree a modest production cut current demand would soon consume those stored barrels, supply/demand would balance and prices would increase. IF the top 5 producers - Russia, Saudi, Iraq, UAE and Venezuela - with combined 2015 production of 30.3 mb/d (Source) were to cut that excess by 1.5 mb/d (5% of combined total) pro-rated to match individual country output and the rest agree not to increase output there would be an overnight solution. It will be argued that Iran - now free of sanctions - will flood the world but they, like all the others, will benefit from the higher prices that will ensue and such restraint by Iran might persuade regional rival Saudi to go for this. I have left the US out of this because the EIA estimates a voluntary US production decline of 700,000 b/d in 2016 which, in itself, is nearly half the 1.5 million needed. It also suggests a further decline of 200,000 b/d in the 3rd quarter of 2016. (Source)

Even assuming the big IF is not achievable that 700,000 b/d reduction in US output added to the estimates of 1.2 mb/d world demand growth in 2016, according to the IEA's Oil market in 2016 report for February, means demand will start to exceed supply sometime during 2016. That means a crude oil price increase.The above mentioned EIA forecasts suggest a WTI spot average price of $50 in the last quarter of 2016 and for 2017. Most US shale oil producers will be nicely profitable at that price level. Add in the big IF and we get a big price increase! And that means a big payback for Russia, Saudi and the other producers for their "investment" in restraint.

I look for investment opportunities under either scenario. Oil "super-majors" have drastically cut exploration expenditure and have also been depleting reserves. Shell replaced only 26% of its production in 2014 and for the three years, including 2014, only 67%. I have not seen 2015 figures but, no doubt, there was no change in that trend nor is change likely in 2016 unless they start spending again. Similar can probably be said of the other majors. Shell is acquiring BG Group and will gain some new reserves that way but will probably need more. BP must add 800,000 per day within 5 years to avoid losing its "super-major"status. It is expected to go ahead soon with the delayed Mad Dog 2 oil project in the Gulf of Mexico. The Shell and BP information came from ft.com articles. I do not think onshore shale oil acquisitions is a solution for the majors because the decline rate is fast and the cost for ongoing production is high. I think their solution will be deep-water exploration where there are massive reserves to be found and the decline rate is only 5-10% annually.

I do not know which driller BP favours but I have stayed with Pacific Drilling (NYSE:PACD) as it has the best fleet of high spec., deep water rigs. I also like and may buy back into Atwood Oceanics (NYSE:ATW). Onshore US I recently bought back - a bit too soon - into Whiting Petroleum (NYSE:WLL) and Oasis Petroleum (NYSE:OAS). I have stayed with Cabot Oil & Gas (NYSE:COG) and may buy more soon. I also plan to buy onshore driller Helmerich & Payne (NYSE:HP). HP has continued to counter-cyclically invest in upgrading its fleet, it is financially very sound and has captured market share from weaker rivals and that gain will stay with it as oil prices recover and drilling restarts. I will keep away from oil shipping companies as, presumably, there will be a glut of those seeking work once the stored oil is consumed.

Summary

I have thought oil prices had hit bottom too many times in the past year or so to say we have now done so but, if the points I mention here prove valid, we are now at or very near the bottom. I have also not speculated on the possibility of conflict in the Middle East that would push up prices but those possibilities are high given that Saudi Arabia is said to be considering entering the conflict in Syria which would add to tensions with Iran with whom it is already engaged in a proxy war in Yemen.

I have mentioned some of my favourites. Others I like include EOG Resources (NYSE:EOG), Pioneer Natural Resources (NYSE:PXD) and Diamondback Energy (NASDAQ:FANG). Readers will have their own as there are some very good companies out there with, in my opinion, bargain basement share prices.

At a time of doom and gloom I hope this article shows there is a glimmer of light at the end of the tunnel.

Disclosure: I am/we are long PACD, ATW, WLL, OAS, HP.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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