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Longterm Outlook Of The Oil And Gas Market

|Includes: DTO, DWTI, OIH, iPath S&P Crude Oil Total Return Index ETN (OIL), SCO, UCO, UWTI, XLE, XOP

Introduction

  • Price of oil over the past year has seen incredible movements from +$100 per barrel to $45 and back to $60 in the past year.
  • An intense global price war has caused supply of crude oil to ignore fundamentals and overshoot demand by approximately 2mbpd.
  • Top 7 oil producing countries are producing near historic levels.
  • Reduced oilfield costs can support $80-90 per barrel in the long-term as proven reserves must be replenished using alternative sources

Saudi Arabia's Surprise Decision Not to Cut Production

In November 2014, Saudi Arabia shocked the world by announcing they would cut production and not support crude prices as they have historically. And so began the crash in crude prices. When oil began sliding, no one had predicted oil to fall below $80 per barrel. The expectations were that when oil dropped to $85 a barrel, Saudi Arabia would cut production to support oil at $100 per barrel.

Overview of Oil Production by Country

There reasoning is simple: everyone is over producing (not just the US). The top 7 producing nations are all producing at or near historic peak production despite the decrease in prices. If Saudi Arabia were to cut production in 2014, they would lose market share and have a difficult time obtaining those customers back. The chart below is a list of the top 10 producing oil countries, including an estimate of their historic peak output.

  Country Production (bbl/day) Percent of Global Output Date of Estimate Peak Production
1 Russia 10,107,000 14.05% 3/2015. 10,107,000 (3/2015)
2 Saudi Arabia 9,735,200 13.09% 12/2014. 9,900,000 (1/1980)
3 United States 9,373,000 12.23% 4/2015. 9,422,000 (3/2015)
4 China 4,189,000 5.15% 5/2015. 4,189,000 (5/2015)
5 Canada 3,603,000 4.54% 12/2014. 3,603,000 (1/2015)
6 Iraq 3,368,000 4.45% 5/2015. 3,368,000 (5/2015)
7 Iran 3,113,000 4.14% 12/2014. 6,060,000 (1/1974)
8 United Arab Emirates 2,820,000 3.32% 12/2014. 2,820,000 (1/2013)
9 Kuwait 2,619,000 2.96% 12/2014. 2,650,000 (1/2013)
10 Mexico 2,562,000 3.56% 12/2014. 3,476,000 (1/2004)

Source: This chart is provided by Wikipedia

Note: Wikipedia is highly unreliable but serves to prove the point that leading producers are all producing at peak levels. For example, Saudi Arabia is currently producing 10.3 mbpd as of April 2015 (source: WSJ)

Supply vs. Demand Globally

In the International Energy Agency's (NASDAQ:IEA) latest report - published publically May 15th, 2015 - has global oil supply at 96 mbpd, up over 3 mbpd compared to 2014 levels. Meanwhile, global demand is only 93.6 mbpd, up 1.7 mbpd from 2014 (Source: IEA's June Report). Key take away is that supply continues to outpace demand and is increasing as OPEC nations continues to increase production to scare off marginal producers.

Fierce Battle for Market Share

All of this has created a fierce battle for global market share. With North America increasingly energy independent, the market war has centered around Asian countries who buy more then they produce. By increasing production and cutting prices, OPEC hopes to increase cost discipline in the industry by targeting marginal producers (producers who drill new wells at cost). Access to cheap money has minimized number of bankruptcies you would expect with prices falling 40% and has forced OPEC to continue to increase production.

About U.S. Shale Production

U.S. rig count is down dramatically from 1560 rigs in June 2014 to 636 as of June, 2015 (Source: Baker Hughes). However, this has yet to cause a decrease in production rates. US producers have been effectively using IOR/EOR techniques such as waterflooding to increase production at mature wells with better cost/benefit results.

Shale wells produce the majority of their production in the first 5 years of being online (falling as much as 75% in the first year alone) (Source: To read more about this issue see Bloomberg article). It will take at least 1 year for US production to begin decreasing due to the lack of CAPEX and rigs drilling new wells.

The most aggressive estimates I have seen have US production dropping by 800,000 bpd by the end of 2015, although I personally do not believe it will be this high as many companies have drilled but not completed wells, allowing them to bring new wells online quickly once the price is right (likely $65-70 per barrel). They have also successfully employed IOR/EOR techniques to increase production of mature wells while maintaining cost discipline.

Reduced Oilfield Service Costs

Producers all over the world have dramatically cut capital expenditures. With lower drilling levels, the oilfield service providers such as Halliburton, Weatherford and Schlumberger's of the world must compete dramatically for business, further lowering the cost for producers. This has caused the costs of drilling and maintaining wells to decrease by as much as 20-30% with more cost cuts expected.

This is most evident in the offshore drilling industry where large scale projects and high capital expenditures make it particularly vulnerable to reductions in CAPEX. Fierce competition has allowed Saudi Aramco to cut day rates to Hercules by half (Source: Houston Chronicle) and Seadrill is willing to cut day rates on current contracts (source: Offshore Energy Today). To note, offshore drilling was in trouble due to oversupply of drilling rigs before the crash of oil prices.

With this new cost discipline approach and fierce competition among service providers, producers are able to support $80-90 per barrel in the long-term, that price is lower for mature wells.

Reliance on High Oil Prices

Every producer in the world has forecasted the price of oil to be $100 and few expected it to decline below $80. With lower oil prices, many producers have increased production in order to meet their obligations.

This is the case for many countries and publically traded companies. Russia and Venezuela who rely on oil as their largest cashflow. U.S. shale producers who sunk every dollar earned into new wells. Even Middle East requires $100 oil to cover their massive economic expenditures (look at Saudi Arabia as they expand their economy, using cash flows from high oil prices - for example, the Kingdom Tower, new refineries and manufacturing expansion).

OPEC vs. Non-OPEC Forecasts

OPEC has forecast crude oil will remain below $100 well into the future, forecasting $76 by 2025 (Source: WSJ). Whereas non-OPEC producers have been talking up the price of oil to end the year at $70. Keep in mind personal motives: Saudi Arabia and OPEC wantto see lower prices to balance supply and demand, whereas non-OPEC require higher prices for long-term survival (they cannot continue to rely on equity and bond markets providing them money to stay afloat).

Longterm Support for Higher Prices

In the short and medium term, oil prices will be volatile - possibly touching lows of $45 in fall as refinery demand decreases as summer driving season comes to an end. Estimates are all over the place; with some predicting $70 per barrel by year end and others expecting to test $45 lows (Source: CNBC Interview with Exxon CEO, Goldman Sachs downgrading oil market). No one knows where oil will go in the short to medium term, myself included.

However, in the long-term proven reserves must be replenished using alternative crude oil sources (eg. offshore, shale and heavy oil) as cheap crude sources have been depleted globally. These alternative sources have higher costs then traditional conventional wells. Therefore, in order to replenish proven resources, higher crude prices are required (given the recent cost cuts, I estimate these sources can be drilled profitably at about $80-90 per barrel).

Conclusion

In the short-term supply exceeds demand by approximately 2 million bpd. This oversupply will cause crude prices to be volatile in the short to medium term. As demand from US refineries decreases in August due to maintenance and lack of demand from the summer driving season, I could see oil prices dropping to $45 for a short period come fall.

However, in the long-term I believe oil prices will hold steady at $80-90 per barrel. Production will decrease as a result of CAPEX reductions sooner rather then later. Proven resources must be replenished with alternative sources (shale, offshore, heavy oil). Producers globally have been able to lower costs by focusing on cost reduction and creating fierce competition among oilfield service providers.

Thanks for reading!

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