Having invested and studied the oil market and oil equities for nearly thirty years, a few lessons learned have remained true over time:
- The oil market is a commodity business, and as such is highly cyclical
- Over the long term, the fundamentals of global supply and demand drive oil prices
- Oil prices drive oil equities higher
Simple enough, but at times hard to remember amid the daily whipsaw twists and turns of market movements that often in the short term are driven by rumor and speculative trading. In this article, we will analyze how these three lessons are shaping up over the horizon, and by leveraging their current trends, we can benefit from investing in oil equities.
Our central thesis is that we see an oil market recovery emerging over the horizon, and that will encourage capital spending growth to revive in oil exploration and production by 2018. Oil equities will follow the fundamentals as the oil market rebalances its global supply and demand driving oil prices and oil companies' earnings higher. Okay, that is the plot, but let's examine the data and analysis to support this developing positive turn of events from the last three years, and why this cycle may be different in magnitude and duration.
1.) Historically, the oil market is a highly cyclical commodity business:
Drawing from historical data contained in the oil multinational: "BP's Statistical Review of Energy" noted in the chart below that since the oil market's inception over 155 years ago, the industry has been marked by periodic boom to bust cycles; with only three periods of elevated prices: defined as sharply higher sustained prices of ten years or more: 1861-1872, 1974-1985, and 1999-2008. It is important to note that of the three elevated cycles, the last two have been closer together and more recent. This higher elevation in prices is to a major degree due to emerging structural issues in the oil market as declining energy intensity, increasing environmental concern, and industrialization of many developing nations at the same time (China, India, Russia, Brazil and others).
Source: BP 2015 Statistical Review of Energy
2.) As always, it is the fundamentals of supply and demand that drive prices and the ensuing price cycle. The current developing catalysts behind global oil supply and demand are two tailwinds on the immediate horizon:
- a supply tailwind driven by reduced exploration from 2015 to 2017
- and a demand tailwind driven by the stimulus of U.S. fiscal policy
As oil prices collapsed in late 2014 and the oil market downturn deepened, oil companies sought to conserve cash flow and began to either defer or cancel exploration projects worldwide, since exploration drilling is a cash outflow activity - a sunk cost. The net result of reduced exploration today limits future production, with the timeline from successful exploration to first oil production can be from five to seven or ten years. The longer exploration is delayed, the greater the ensuing magnitude and duration of delayed future oil production.
The timeline chart below highlights several important takeaways from the lack of current exploration:
The net impact of reduced global exploration and deferred investment sanctions from 2015 to 2017/2018 will create a global oil supply shortfall by roughly 2020. Rystad Energy, a Norwegian oil & gas consultancy firm, has estimated that combined with natural depletion from currently producing oil fields and the lost production opportunity from the reduced exploration will necessitate roughly an additional ~11 M b/d of future production.
- This supply shortfall will allow global oil demand that we expect to grow at roughly 1.2 Mb/d in the near term to overtake supply and drive oil prices higher -"demand drives price" by 2020. Even with U.S. unconventional shale production back in the growth mode, Saudi Arabia, Iran, Iraq, and other key OPEC producers are producing near their maximum levels and this includes the Russian Bear, supply growth by 2020 will not be able to match demand growth (see the demand tailwind below).
- The economic resiliency of most U.S. shale (tight oil) producers to survive this recent oil price collapse and continuously improve their production techniques, driving drilling costs down the well hole, has been impressive and surprising. However, U.S shale production has a relatively short history - data set, costs have been reduced during an overall cost deflation period in the oil patch, and unconventional shale wells experience very steep declines that necessitate continuous reinvestment to overcome depletion and generate net growth. Also, most of these cost gains and continued shale production have been from their best production wells; to maintain production growth, shale producers will have to bring online production from their marginal wells where costs are higher and profitability is lower. Once prices start to inch forward, costs always follow prices upward and margins tighten. So, the full extent of just how much future growth the U.S. shale producers can deliver on a sustained and profitable basis is relatively unknown and speculative. The U.S. Energy Information Agency - EIA has incorporated this realization into their recent "Annual Energy Outlook 2017": "Crude oil production in the Reference case increases from current levels, then levels off around 2025 as tight (shale) oil development moves into less productive areas." (pg. 14) "Despite rising prices, Reference case U.S. crude oil production levels off between 10 and 11 M b/d as tight oil development moves into less productive areas and as well productivity gradually decreases." (pg. 44) Based on EIA's projection of flat long-term US oil production this would constrain higher non-OPEC production and that would create support for higher long-term oil prices.
- Higher oil prices will eventually resuscitate global exploration, accelerating future production post 2020 -"supply chases price."
- Now, the supply/demand timeline may not occur exactly as depicted, durations may be longer or shorter. However, the pivotal question is duration, does the cycle last seven, ten, or fifteen years. My analysis leads us to lean toward a cycle of a longer duration driven by the magnitude and extent of time that exploration activity has been curtailed from 2015 to 2017/2018 and at an expense of roughly $300 billion in lost exploration projects.
Additionally, in the near term by 2020, there are other positive supports for higher oil prices.
- Declining oil discoveries
- Lower breakeven cost
- Declining global production driven by:
- Natural reservoir decline rates
Offshore discoveries peak by 2010
2010: Discoveries Peak 2013: Spending Peak
Global offshore discoveries peaked by 2010 driven mainly by the Brazilian sub-sea discoveries. However, capital spending by oil companies did not peak until 2013, which suggests that spending more in exploration does not necessarily lead to finding more oil & gas resources. Indeed, per "Rystad Energy," "2016 total offshore discovered liquids resources … were 90% lower than in 2010 … in fact, total global discovered volumes (oil & gas combined) are at an all-time low since the 1940s. In 2016, the average liquid content in the discovered resources was merely ~40%. Even more tellingly, the replacement ratio* for liquids in 2016 was below 10%. For comparison, the replacement ratio for liquids in 2013 was as high as ~30%." (*Replacement ratio is the net addition of oil reserves over production.)
Another price support in the near term has been the significant decline in breakeven prices for oil.
The chart below, The Next Oil Cycle, draws on historical global supply and demand data from OPEC Monthly Reports. Using statistical techniques tempered by my oil market experience garnered over the years, I projected expected oil supply and demand to 2025 from OPEC's historical data going back to 1999. I included in my projections the impact of recent agreements to curtail OPEC and key non-OPEC producers as Russia, and production trends in U.S. onshore tight oil (shale) producers. Based on the resultant supply and demand market curves coming into balance in the base, high and low cases, I projected expected oil price curves. In our base oil case, we see the supply/demand imbalance beginning to tighten by 2018/2019 and leading to a market rebalance by roughly 2020 as global supply turns to a deficit. In the high oil case, global demand accelerates as fiscal policies stimulate world economies better than expected and drive prices higher. In our low oil case, several factors could contribute to a trend of lower oil prices - either a lack of global fiscal stimulus policies, or insufficient fiscal stimulus, and/or a production supply response by OPEC led by Saudis to limit higher oil prices that overwhelms any global fiscal stimulus policies, causing oil prices to retreat lower.
U.S. fiscal stimulus policy drives global GDP and oil demand:
Robust U.S. fiscal policy initiatives have historically fueled U.S. economic growth (GDP). Likewise, a stronger U.S. economy often strengthens the U.S. dollar as an expansionist economy pushes interest rates higher attracting global investment to the U.S. dollar. A higher U.S. dollar, in turn, generates greater U.S. imports as Americans have greater purchasing power relative to other currencies/nations. We used historical data from the International Monetary Fund - IMF and correlated the growth in U.S. GDP and in U.S. imports from 1980 to the present and found a significantly high correlation with an R-square of 80%.
Again using historical data from IMF, we correlated the growth in U.S. GDP with the foreign exports and again found high correlation factors with key exporting countries.
We re-calibrated our oil supply and demand and price models, to incorporate the stimulus impact of fiscal policies upon oil prices. The net effect could move the oil cycle higher and earlier.
Our near-term conclusion is that we see oil prices recovering to a sustained range of $60 to $70 per barrel by 2018 as global supply and demand begin to rebalance, and the current global oversupply hangover begins to diminish. The market rebalancing effect will begin to stoke fears of inadequate excess production capacity that occurred from 2010 to 2013, and that will be an additional catalyst for speculative activity that will fuel prices higher. Elevated prices will drive demand along the global oil market supply chain; particularly demand for exploration rigs. From my research and my experience working for an oil multinational managing project economics, we have found that oil prices stimulate capital spending by the major international oil companies on a lag by one year to 18 months, as the major oil companies will look to a sustainable level of elevated prices before they commit to higher capital budgets on a long-term basis. If prices firm in the $50 to $60/bbl. range by late 2017/2018, major oil companies will begin to adjust their budgets in 2019 by funding first projects with lower capital requirements and lower exploratory risk with an eye to 2020 for significant budgetary increases. But once major budgetary changes by oil companies take root by 2020; demand along the oil market supply chain will begin to accelerate. The reasons for the budgetary caution are several concerns of over-stimulating the supply chain leading to cost inflation and a resultant collapse of margins as occurred from 2010 to 2014, a fear of oil prices collapsing, and simply because altering the investment process by the major oil companies is a slow "titanic" process.
To the point of oil prices collapsing, skeptics will note that higher oil prices will undoubtedly provoke a supply response from Saudi-led OPEC, and I agree it will. The Saudis are motivated by two major concerns and will monitor global supply and demand (prices) very closely. Those two concerns are encapsulated in their 2014 two-fold response, a tactical response to regain market share in the near term, similar to what they did in 1986, and more critically a long-term strategic response to lengthen the horizon timeline of a world no longer dominated by fossil fuels. What will mitigate the OPEC supply response is the demand tailwind - global fiscal stimulus led by the U.S. The supply tailwind is not sufficient by itself, it will be necessary to be combined with a global demand tailwind outlined earlier in this note to mitigate any supply response by the low-cost producers as OPEC and Russia.
Consequently, although oil prices will begin to gradually move higher by the end of this year, it will take two to three years for the oil market to rebalance supply and demand. After which, we will begin to move into an oil supply deficit as demand even at an expected pace of ~1% growth per annum will move ahead of constrained supply due to the lack of new production from delayed exploration from 2015 to 2018. It is during this period, post 2018/2019 that we will likely experience a fourth cycle of elevated prices for several years.
3.) Oil prices drive oil equities
We looked at daily historical data obtained from EIA and Yahoo.com on Brent oil prices and the XLE, an index of major oil equities from 2000 to the present. We found a significant statistical correlation between oil equities and oil price, R-square of .62.
Source: Yahoo.com, EIA
Overall, we see positive signs for the oil investor in the near term, but oil prices will remain volatile from 2017 to 2019 as they inch forward. For investors, looking to position themselves early, they may want to look for discounted oil equity valuations. Particularly, for oil equities that are levered to oil prices, possess strong balance sheets, and have a pipeline of developed projects with sunk costs behind them about to come online that can generate positive internal cash flow generation. We will examine some of these opportunities in closer detail over the next few publications. For now, keep your eye on the fundamentals: supply, demand and U.S. fiscal policies.
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.