A Secular Change In The Oil Market

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Includes: BP, CHK, COP, CVX, DVN, XOM
by: Bidness Etc

Will Oil Prices Remain at these Levels?

Recent Trend

Oil prices have shown a decline of 22% since the beginning of 2Q2012, and are trading at $80.15/bbl for West Texas Intermediate (WTI) crude oil. There are several reasons for the decline in oil prices, in both the local and international markets, and can be divided into structural/secular and cyclical changes.

Structural Changes

  • Increased production of oil from Canadian oil sands.
  • Increased supply of unconventional oil and gas in the U.S.

Cyclical Changes

  • The potential slowdown in the U.S. and Chinese economies.
  • The looming debt crisis and the economic recession engulfing the European Union.
  • The easing of tensions between the West and Iran, after the latter allowed International Atomic Energy Agency (IAEA) inspectors to visit its nuclear sites.

The focus of this article will remain on the structural changes in the oil industry.

Natural Gas Prices

Natural gas prices have dropped by around 40% in the last one year, due to excess supply of the fuel in the U.S. The reason for this excess supply is the technological advancement and profitable extraction of shale gas through hydraulic fracturing and horizontal drilling in the past few years.

Natural gas prices are trading at $2.70/mmbtu, which is not only significantly lower than the price levels from the previous year, but are at a significant discount to international prices.

The reason for this disparity occurred and remained is the fact that natural gas is normally transported through pipelines, since in its gas form, it takes up more volume per unit of energy produced, which is why it is not feasible to transport it via shipping.

U.S. Import and Consumption Patterns

The U.S. imports 6.3 million barrels of foreign oil every day (excluding Canada), while it consumes 18.2 million barrels of oil every day.

The Energy Information Agency (EIA) expects U.S. oil imports to drop by 20% by 2025. British Petroleum (NYSE:BP) has projected that the U.S. will produce 94% of its energy domestically by 2030, increasing from 77% produced now, since oil imports are expected to fall by half. Analysts at Citigroup (NYSE:C) are of the opinion that the U.S. may be able to achieve energy independence by 2020.

Shale Oil

The U.S. has ample reserves of unconventional oil in different formations spread over the country. However, the important formations are Bakken in North Dakota, Eagle Ford on the Gulf Coast, and the Monterey/Santos formation on the West Coast. The total estimated reserves of unconventional oil are approximately 24 billion barrels of oil equivalent (BBOE).

The expected production of unconventional oil is 720,000 barrels per day for 2012, and is anticipated to double by 2035 to reach 1.23 million barrels per day.

Government Regulations

  • The federal government has made it mandatory for automakers to increase average fuel economy standards, to up to 54.5 miles per gallon, by 2025.
  • A 2007 law requires oil companies to increase production of renewable auto fuels by 2022.
  • California is making it mandatory for utility companies to buy up to 60% more renewable-sourced electricity by 2020.

Increased Oil and Natural Gas Production

Due to the depressed prices of natural gas, producers are shifting from gas to liquid-and-oil plays. We believe due to this shift, domestic supply of oil in the U.S. will increase, and may exert pressure on oil prices in the longer term.

The low prices of natural gas have been the cause of increased conversion of electric utilities to gas as a fuel input, due to lower working capital requirements, and the increased customer satisfaction due to reduced electricity bills.

It has been suggested that transportation be converted to natural gas. This will have a significant impact on oil demand in the U.S., since according to government sources, about three-fourths of the oil demand is driven by these consumers.

Canadian Oil Sands

Due to the improvement in technology with the introduction of hydraulic fracturing, it has become economical for Canada to tap its vast resources of oil reserves, and this has improved exports to the U.S.

Technological Changes and Increased Efficiency

There is an increased effort in the U.S. to improve energy efficiency, and a continuous effort to achieve technological advancement. The increase in efficiency and technological advancement with the introduction of efficient engines, hybrid cars and electric cars will reduce oil consumption in the U.S.

Demand and Supply of Oil in the International Market

Demand for oil will continue to grow going forward due to the demand from emerging markets, as the per capita income increases and demand for oil is expected to outstrip demand from OECD countries by 2Q2013.

Oil supply is expected to remain steady in the international market, since more countries, including China, are considering the production of unconventional oil and gas reserves. The reduction in oil output from Iran due to economic sanctions has been offset by increased output from Saudi Arabia and Iraq (expected to reach output levels prior to the first Gulf War).

Export of LNG

The largest LNG plant is being built on the Gulf of Mexico by Chinere Energy (NYSEMKT:CQP), for the sole purpose of exporting natural gas to enjoy the higher prices being offered by international markets, after conversion to LNG, to make it financially feasible.

Impact of Structural Changes

Since the aforementioned factors are structural in nature, the impact of these changes will be gradual and prolonged.

We are of the opinion that the depressed natural gas prices are an anomaly, and consumer demand will shift from oil to natural gas to reduce costs, while producers will shift supply toward liquid-and-oil plays to enjoy higher revenue and profitability.

In the longer run, we are of the opinion that the shifts in demand and supply for the fuels will balance out, and market forces will determine the prices of natural gas and oil depending on the path taken by the cyclical factors affecting oil prices in the world today.

Companies Affected Due to Structural Changes

There are many companies that will be affected due to structural changes in the Oil and Gas Industry. Few of the major O&G companies are: Exxon Mobil Corporation (NYSE:XOM), ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX), Chesapeake Energy (NYSE:CHK), Range Resources (NYSE:RRC) and Devon energy (NYSE:DVN).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.