Oil To $100? Probably Not Yet

by: Ian Bezek

Oil has rebounded strongly since 2016.

I stand by my long-term call of oil returning to $100/barrel.

But there's too much enthusiasm here, expect a pause in the interim.

I'm a long-term bull on oil. I wrote why crude would power past $100 back in 2016 when it seemed as though no one liked petroleum anymore and a response to my article said oil would go to $10. So far, oil has proven the bulls to be on the right track for investors in crude futures or ETFs such as The United States Oil ETF, LP (USO). That said, there's no guarantee that the move back to $100 will come in a straight line, and I think the energy faithful are starting to get ahead of themselves in the short run.

We've seen various media articles this year suggesting a potential near-term return to three-digit crude prices. And more recently, we got an 86-page report from Burggraben Capital making the case for near-term $100 oil again. Crude oil speculators have also been maintaining record long positions after ramping up their exposure last winter. (Crude oil speculative net positions, data CFTC, source)

I read much of Burggraben's report for a sense of what the bull case looks like at its most comprehensive take. They make a few key points.

First, they argue that the world is finally seeing significant growth in almost all major economies. That's something that hasn't happened since pre-2008. This is leading to significant new oil demand in places like India for 2018, whereas demand didn't rise there at all last year. Burggraben argues that accelerating economic growth will lead to a shortfall in oil production versus demand in 2019, resulting in $100 oil.

Bears contend, of course, that shale can make up for new demand. Burggraben freely acknowledges that shale is adding 1.4 million new barrels of production annually, a figure that should rise even more as drilling activity is on the rise again. However, they argue that this is insufficient to offset falling production levels at mature fields.

And they also contend that we are at "elevated" risk of supply disruptions. Here, their case is pretty shaky. They contend Venezuelan production will fall even more, but it's already down 50% and the government is on the way out, so don't expect too much more help for the bulls from there. Once oil revenues fall too low, the government won't be able to pay the military or budget for basic necessities. There's a limit to how far production can fall before the regime is changed. Burggraben also points to an increased risk of terrorist attacks in Colombia and Nigeria among other such concerns. And sure, bad stuff can always happen, but what's unique about 2018? There's usually something going on geopolitically somewhere in the world that could disrupt oil production.

Much of the presentation then goes on to explain why oil supply will drop off more quickly than analysts expect. Their arguments on the decline of new big finds, the unlikelihood of shale as a long-term solution, and so on are in line with other research I've read on the subject. They also make the case that EVs are over-hyped, and even with significant adoption, would only modestly cut much into oil demand. The story, as it has long been, is demand growth out of China, India, and other poor-to-middle income countries as they modernize. I agree. I'm a long-term bull on oil.

But little of that matters to oil in 2018 or 2019. For now, the shale producers, I'd argue, can control the price. The oil bulls, such as Burggraben, flatly claim that: "The Future curve does not help to understand future crude oil prices." Others would argue, however, that the shape of the futures curve says a lot about future market conditions. Shale producers, for example, can sell futures for later years, say 2022 and have a guaranteed price for oil production they haven't started building out the infrastructure for yet.

Take the locked-in prices to a bank or the stock market, and investors are more likely to pony up capital knowing the precise revenues they'll be getting in coming years. For now, shale producers can keep selling out their future production. If they can do so profitably (and they can at today's prices), they'll borrow more money and bring on yet more supply (drilling activity is up strongly over the past 12 months).


US Rig Count data by YCharts

If we see the shale producers run out of new marginal supply, we might expect the back end of the futures curve to spike, but so far, that's not happening.

Switching gears, much of Burggraben's argument is simply a bet on stronger global economic growth. Such conditions generally correlate to a weaker dollar (a big reason why oil is up so much over the past year) and accelerating inflation/consumer spending. Burggraben notes that if their economic growth forecast doesn't pan out and we get a recession instead, oil could go back to $40/barrel. So make no mistake, despite dozens of pages of analysis, in their view, $100 oil in the near-future is still to a significant degree a bet on accelerating world GDP growth.

That could certainly play out. But I'm skeptical we're about to get a massive surge in global economic activity in the wake of rising interest rates and curtailed Central Bank liquidity. China's credit crunch appears to be worsening as well - who knows when their mounting debt pile will finally reach its sustainable limit, but the smart money is betting on things decelerating, at a minimum.

Overall, I hope oil keeps going up, it's good for my own wallet as an investor in emerging economies with oil exposure. And oil stocks, for what they're worth, appear quite cheap. The energy sector is still in the doldrums, even with oil prices surging. It was remarkable that Exxon Mobil (XOM) for example, traded back at 2016 lows earlier this year with oil up from $30 to $70 since then. All that said, I don't see this as the time to bet the farm on higher oil prices. I expect the rally to run out of steam here fairly soon. My call: oil is going back to $100 - but not before 2020.

Disclosure: I am/we are long XOM. 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.