- The "Last Great Oil Bull Market" has begun.
- Supply and demand for oil are in balance globally, and demand is rising faster than supply.
- U.S. shale while prolific now is already running into cost and production limitations.
- Deepwater oil development is not coming back due to the time frame problem with EVs coming.
- Saudi Arabia is regaining oil pricing power. Buy oil stocks NOW!
Oil just entered a new bull market phase by rising 20% in price since I started imploring people to buy oil stocks a few months ago. While there will likely be a retracement of some sort, make no mistake about it, oil is going to rise dramatically in the next few years and hold a higher price level plateau until electric vehicles take hold.
Smart investors, who can control their emotions, should be overweighting oil and oil services stocks right now.
Oil Is Now In a Cyclical Bull Market
From its bottom in June to last week, the price of Brent Crude Oil rose well over 20% signifying a cyclical bull market. As is part of my "Core 4 Investment Method," we want to respect price trends.
With oil demand and supply roughly in line now, the question turns to inventories. As contributor Adam Mancini recently pointed out, oil inventories are falling and could be set to take another tumble.
Just this week, Saudi Arabia, announced more export reductions, which will certainly impact the markets. As I'll cover below, OPEC's cuts are having a great deal of success and seem to be on the verge of more. On balance, most of the evidence suggests that oil prices rise into new trading ranges.
Since I published the viral article An Iran War Is Coming - Buy Oil Stocks Now, I have been contacted by numerous finance, analysis, and media professionals (interestingly, no academics). One is futures trader Ralph Preston with Heritage West Financial, Inc. whose very informative website on futures trading I visit often. His expertise on monetary policy and Middle East foreign affairs has landed him in WSJ and Thomson Reuters, as well as, on Bloomberg.
Preston is looking for oil to make a run at quarterly resistance of $63 by February, though he is cautious about a retracement to monthly support at $48. If oil does fall back, that would appear to be another buying opportunity. I will be featuring some of Mr. Preston's thoughts and Heritage West's charts in an upcoming article about oil price ranges in the short to intermediate term.
Ultimately, for both fundamental reasons and emerging technical reasons, it does appear that the current cyclical oil bull market will have legs so long as OPEC and Russia continue to maintain cuts. Other factors are also contributing to the firmer oil prices in what I believe to be the beginning of the last secular oil bull market.
OPEC Cuts Are Being Successful
The OPEC and Russia oil production limits have been met with great skepticism by many American investors. The shrill headlines and cries that OPEC has lost its control of oil markets are proving to be wrong just as I have said would be the case over and over.
According to the International Energy Agency, global oil supplies dropped by 720,000 BPD. Despite OPEC cuts, most of the decline came from non-OPEC nations. OPEC's share of the decline was only 210,000 BPD. That means around the world, ex-shale, oil production is falling due to the lower oil prices stunting new investment - which can't be turned on like switch.
As a result of the falling inventories, we now have a key indicator showing that the supply limitations put in place by OPEC and Russia, and low prices in general (which were caused by OPEC pumping), are having the desired effect. Oil has swung from contango to backwardation for the first time in a long time.
As Nicholas Johnson and Andrew Dewitt of PIMCO just covered, oil markets moving from contango to backwardation have a few important impacts.
First, the move to backwardation from contango indicates that OPEC’s production quotas are having some success in reducing the overhang of inventory, and thereby supporting a spot price for oil that exceeds the futures price one year out. This gives OPEC an edge from a relative competitiveness perspective, given that OPEC producers sell almost all of their oil on a spot basis, while U.S. shale producers hedge a significant volume of their production in the futures market.
Second, the shape of the oil curve has historically been one of the best predictors of future returns, so the move to backwardation has significant implications for commodity investors. For example, subsequent four- and 12-week returns for long oil futures positions in backwardated oil markets have averaged 1.3% and 2.9%, respectively, compared with returns of -1.7% and ‑3.8% for the same periods during contango markets.
Third, backwardated markets give rise to “roll yield” opportunities for commodity investors – that is, the ability to generate returns by rolling a short-term contract into a longer-term contract. Simply put, with the oil market in backwardation, investors can earn a positive return from being long oil even if the spot price doesn’t change.
For those who have used or are considering using the U.S. Oil Fund (USO) or iPath S&P GSCI Crude Oil Index ETN (OIL), this might be a rare instance where those funds will work for more than day trading. Under contango, those two funds are constantly fighting the roll pricing, but with backwardation can actually have an advantage. If you don't understand that, read this Seeking Alpha article from a couple years ago.
The impact of backwardation is extremely important to how the industry operates. It means that producers will not be as compelled to rush to production now. They can allow higher oil pricing to drive their revenue versus "drill baby drilling."
Backwardation will impact all producers, including shale producers who need to still get a grasp on debt. By keeping production closer to flat than expanding rapidly, shale can ride prices higher and allow revenue to expand just as many companies face debt issues in coming years. OPEC in effect could be saving some of the higher debt shale plays.
By subduing the high growth of shale by getting the oil market back into backwardation, ultimately, OPEC does become the swing producer on oil again soon. Not only does OPEC still produce the cheapest oil, but as I cover below, shale's life, while prolific, will not be a long one. Think James Dean when you think shale.
And, while I believe OPEC does regain swing producer status very soon for oil, even they have little spare capacity. That could mean a surge in oil prices at some point even higher than I project. The risk is that lack of deepwater investment will ultimately cause a price spike that cannot be quickly remedied. That in turn usually leads to recession, so be aware.
Shale Is Strong, But Not That Strong
The common wisdom is that U.S. shale is going to be prolific for a long time. That just isn't likely true, however. What we now know is that with the exception of the Permian Basin and STACK/SCOOP, most U.S. unconventional shale basins are near peak production, and the cheapest oil is giving way to more expensive oil as drillers move away from the heart of the plays.
Across the shale complex costs have drifted higher this year. Service companies, such as Schlumberger (SLB), have been reporting improving revenues on rising costs and volumes, giving them more pricing power. For E&P companies, they have to choose whether it is profitable to pay the higher rates, or sit back and wait for higher oil prices to move forward on both new wells and well completions. Currently, DUCs - drilled but uncompleted wells - sit at over 6000.
The best example to convince those who believe that shale is forever is that the Bakken is already edging into decline. This prolific play, which I visited to research multiple articles for MarketWatch in 2012 and 2013 when it was booming, is clearly flat lining. Real estate values peaked a couple years ago, employment is no longer expanding and the "oil boom" is a thing of the past. Communities are already trying to figure out how to move on from the oil expansion.
Over in the Niobrara, they cut rigs by two the past month, and companies are running into cost issues related to further development. And, as Whiting (WLL) discovered recently, well production wasn't up to par, and decline rates were dramatic.
Even the prolific Permian is not immune from what is clearly a peaking process in my view for shale. According to Wood Mackenzie, Permian production could peak by 2021.
On top of all that, add the concerns for legacy operators that, according to hedge fund manager Russell Clark, their decline rates have been rising dramatically. To replace that production, companies are faced with a difficult decision, spend money now or wait.
Ron Patterson covered at OilPro.com that U.S. Shale Could Peak Before 2025. This is in line with EIA predictions that U.S. unconventional oil production is not eternal and likely peaks by the mid 2020s.
The pressure on oil prices that U.S. shale has a limited lifetime could be significant as markets realize the bind that some U.S. producers are in. On the one hand, they have oil to drill for now, but on the other, they need higher prices or many will never pay off their debts.
Deepwater Oil Drilling Is Still Weak
Deepwater drilling all over the world has come to a screeching halt. Only a few projects have come back online of any significance. We know that projects from China to the North Sea to Africa to the Middle East and the Arctic have been canceled. Most are not coming back. The payback time is too long.
IHS Markit makes it pretty clear that the deeper the water, the less the comeback for offshore. Here, we see day rates and utilization are still very low and barely have moved off of bottoms:
As I discussed in Deep Water Drillers Are Doomed Even If Oil Prices Surge, I expect the outlook for deepwater to remain subdued. I know that certain CEOs of drilling companies are forecasting day rates to push towards $300 by next year, but I don't see it.
The signs of long-term chronic illness in offshore, especially deepwater, is seen throughout the industry. According to Bristow CEO Jonathon Baliff, "the offshore transportation market is broken economically,” he said during a panel session on the offshore oil-and-gas sector at Helitech International in London, England. “It was built for a very different economic structure.” He went on to say:
“Bristow, before the downturn, had one-month contracts that didn’t get cancelled for 30 years... Think about how you man a one-month contract, or you work with your OEM on a one-month contract. But it never got cancelled. And now five-year contracts, 10-year contracts getting cancelled.”
Think about how short cycle the offshore industry is getting if they aren't even maintaining transportation contracts. That is a bad equation for the deepwater drillers who rely on big long-term investments.
As I discussed in my recent interview for Cheddar TV, everybody who wants to know, knows that electric vehicles are coming. The payback on expensive long-life megaprojects are too long for banks and oil majors to gamble one, hence, the focus across the industry on short cycle projects, i.e. fracking in the U.S.
Here's more. One of my new clients recently retired from Halliburton at 29 years old. I say retired because he did not see a future in the industry after what he is seen in North Africa and the Middle East. He has told me that he has seen projects that were ready to go get cancelled and infrastructure idled across the regions for deepwater projects the past two years. We specifically discussed Angola and other African nations where there are almost no new projects getting started anymore. Most of the people for the major service companies have been getting pulled out. He was one of them, and now he is on scholarship at Indiana University for an MBA and beginning an internship with DowDupont (DWDP).
Without new deepwater projects to replace declining existing projects, the short cycle projects, fracking and shallower water, can only keep up for so long. This will help create more upward pressure on oil prices and give OPEC more leverage over time as it once again becomes the global swing producers.
The U.S. cut lease rates in the shallower Gulf of Mexico shelf to incentivize short cycle drilling. Those projects run a lot like fracking, only producing high volumes for a few years. These are not long-term solutions for oil, but of course, maybe oil doesn't need long-term solutions. One could consider the U.S. government's focus on short cycle Gulf of Mexico as an indicator of both a recognition of the beginning of the end of the oil age and a potential supply disruption elsewhere, i.e. Iran.
As I see it, deepwater oil is never going to come back much, which is I see Transocean (RIG) as eventually going bankrupt, like Seadrill (SDRL) just did. Transocean has great new rigs, and when the bondholders become shareholders, the company will become a, maybe the, leading maintenance and expansion company. Sell Transocean shares if you own them on the stubborn false hopes of blinded backwards looking longs. I originally suggested selling both Transocean and Seadrill in 2015 on MarketWatch.
Oil Demand Continues to Rise
At least in the short term, oil demand will continue to rise. That should last until around the middle 2020s. At that point, we will see even more fuel efficient ICE cars and a bigger push towards EVs and hybrids.
For now, however, the IEA has noted that oil demand rose 2.3 million barrels per day year over year for Q2. The estimate for demand growth for 2017 was revised upward as well to 1.6mbpd. Demand was buoyed by strong demand in the U.S. and Europe on strong economies and lower oil prices.
With oil prices low, the uptake of EVs, which remain relatively expensive for now, has not accelerated to a pace that would stunt oil demand. To be sure, that will happen someday as oil gets more expensive, however, that day is awaiting another advancement in EV technology and higher oil prices.
The EIA doesn't project oil demand for a long time and neither does OPEC. While I take their projections with a grain of salt, it is clear that the decline of oil demand will not be a sudden event as Tony Seba suggests.
Because oil demand will not fall rapidly, OPEC and Russia have plenty of room to maneuver in order to drive oil prices higher during the end of the oil age.
Saudi Aramco IPO and Russia
There are very motivated parties to wanting to see oil prices higher, including Russia and Saudi Arabia. Russia derives over half of its federal revenue from oil and gas exports. Higher prices are in their interest. Saudi Arabia, despite being in the early stages of diversifying its economy, gets most of its revenue from oil exports as well.
The actions of both nations should be seen through the lens of maximizing their revenues and supporting their economies. For Russia, that means thinking twice about its geopolitical actions. For Saudi Arabia, that means getting a good return on its Saudi Aramco IPO.
In the case of the Saudi Aramco IPO, I am thinking of it much like I do when an private equity firm "cashes out" of a position. In general, they are looking to get full value today for an asset that might depreciate or not provide as great of a time value adjusted return if held. In short, I think Saudi Aramco is getting sold to the suckers who believe that oil is forever.
Without deepwater development and shale running its course, the price of oil will rise in coming years. That will be especially true now that OPEC and Russia are on the verge of getting a handle on oil prices with cuts that have brought supply and demand back into balance. Watch both nations' actions and expect a surge in oil prices going into the Saudi Aramco IPO.
The Peak Oil Plateau Is Coming
I know when some people hear "peak oil", they go into ideological convulsions. When I talk about peak oil, I mean for both supply and demand. While we can drill oil for a very long time, the reality is that economic oil is depleting, and large scale discoveries are not fully replacing what is depleted.
Also, demand for oil is going to fall someday. How fast is up for debate, but as I said in the Cheddar interview, I think oil demand is likely to start falling by the middle to late 2020s. It will not be a steep curve either. It will be shallow as internal combustion engines stay on the road a long time. It won't be for about a decade after EVs and hybrid car sales surpass ICE sales that we see a steep decline in oil demand.
The result will be a period, perhaps 10 to 20 years long where oil demand and supply are both around 100 million barrels per day. During the front part of this period, I expect oil supply to be controlled very well by OPEC. By the second half of the period, when shale supplies have turned over, supply will also remain subdued.
So, the bottom line is this. Oil is going higher based upon supply and demand because supply can be controlled and then will fall naturally. Deepwater drilling all over the world has come to a screeching halt, and shale does not have the juice to be a major change factor for much longer. In addition, there are very motivated parties to wanting to see oil prices higher and EVs are a decade or more away from making a significant dent.
I expect oil to get back to around $80 per barrel by 2020, sooner, if as I have postulated there is a broader war in the Middle East involving Iran. If that happens, then we will see oil over $100 per barrel again. I will follow up on this scenario again separately.
Oil Stocks To Buy
I covered all three of these companies already, but I will repeat myself. That is as close to pounding the table as I get.
If you don't own Encana (ECA) yet, then you are missing the boat. The company has over 6,000 drill locations in the Montney shale play in Canada which compares to the Eagle Ford and Marcellus in the U.S. It is a gas rich play but also strong on liquids. Encana also has about 10,000 drilling locations in the Permian Basin. Read this article: Buy Encana On Maximum Pessimism. Then, but some Encana stock, my price target is $20 in the next 2-4 years without the Iran war.
Occidental Petroleum (OXY), which I've noted a few times, is also still a buy. It pays nearly a 5% dividend, but doesn't have the upside of Encana. I project Occidental to have about 50% upside the next few years, but a very high likelihood of being acquired by Exxon (XOM) or Chevron (CVX). Chevron is very active in the Permian and committing $4 billion to developing its land there, so Occidental would be a logical bolt-on acquisition target.
I am also a buyer of Helmerich & Payne (HP), which is languishing near $50 per share with a fat dividend over 5%. Helmerich is the largest land-based U.S. driller with some operations in the Gulf of Mexico as well. Drillers are very correlated to oil prices and in fact get some amplification very often. If oil prices rise as I suspect and U.S. shale maxes out, then Helmerich can double in the next several years and regain new highs in my opinion.
Be careful when accumulating any oil stocks. They get overbought quickly and buying on pullbacks will be a key strategy for those who want to take part in the last great secular oil bull market.
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