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Expect Much Higher Oil Prices As The Cycle Comes To An End

Oil Rig

In my last article for OilPrice.com (May 16, 2016), I laid out my reasoning for a prediction that the Global Oil Markets would soon be back in balance. Picking an exact date when an oil cycle will end is difficult, but they do call them “cycles” for a reason. This cycle is no different than all of the others that came before it. Oil producers and consumers respond to price changes, which brings supply & demand back into balance, just like they always do.

The last six major oil price cycles lasted an average of two years. This one started in July, 2014.

On June 14, 2016 the International Energy Agency (IEA) issued their monthly Oil Market Report. In the report the IEA revises their first quarter increase in global demand forecast from a 1.4 to 1.6 million barrel per day year-over-year increase. They are also forecasting a big spike in demand of 1,270,000 barrels per day from the 2nd quarter to the 3rd quarter. Since demand ALWAYS spikes in the 3rd quarter, this was not a surprise to anyone.

Link to IEA Oil Market Report summary: https://www.iea.org/oilmarketreport/omrpublic/

Since this cycle has been so severe, I predict that it will not end well for speculative traders that continue to short oil futures. If some of you purchased a gas guzzling SUV because you believed the talking heads that said oil would never sell for $100/bbl again, you may want to consider a smaller second car.

• Global oil production in May was 590,000 barrels per day less than it was a year ago.

• Nigeria’s oil sector is under attack and the situation seems to be getting worse

• OPEC production fell by 110,000 barrels per day as increases in Iranian production were more than offset by big losses in Nigeria, Libya and Venezuela

• Global demand is up 1,600,000 barrels per day year-over-year as Chinese demand has held up and demand from India is very strong

Canadian wildfires at their peak took 1,500,000 barrels per day off the market. This production should be restored in the 3rd quarter. The situations in Nigeria, Libya and Venezuela are much worse. Inf fact, there is now concern that the government in Venezuela may collapse under the debt load created by low oil prices.

The direction of the oil market should now be crystal clear to everyone. Demand growth is relentless. The products refined from oil are essential to a high standard of living on this planet. We will all complain when gasoline is back over $3.00/gallon, but we will continue to pay for it. Within 6 to 9 months, demand for oil should exceed production. High storage levels provide a cushion, but oil prices will continue to ramp higher.

What are other analysts predicting?

• Raymond James says West Texas Intermediate (WTI) will average $60/bbl in the 3rd quarter and $75/bbl in 2017

• Morgan Stanley recently raised their long-term oil price for Brent by $10/bbl to $80/bbl

For those of you investing in upstream oil & gas companies it is important to note that “$70 is the new $100”. By this, I mean that the improving well results and much lower drilling & completion costs of horizontal wells in the U.S. shale plays makes the economics for new wells about the same at $70 oil as they were a couple of years ago at $100 oil. Related: Cheap Energy Storage Is Set To Undermine Fossil Fuels

Keep an eye on the frack sand companies (EMES, FNSA, HCLP, SLCA). The upstream companies are getting better well results by using a lot more sand to complete horizontal wells. To stabilize U.S. oil production, the upstream companies will need to complete twice as many wells as they are completing today. Demand for frack sand could double within twelve months.

Natural Gas Market

I want to shift gears and remind you that all upstream companies produce a combination of oil, natural gas and natural gas liquids (NGL). Each product trades on a separate market.

The U.S. natural gas market is isolated from the rest of the world. Although we are the world’s largest gas consumer, the U.S. has very little import capacity other than pipelines from Canada. Canadian production has declined, so they have less gas to send us. We are now exporting gas via pipeline to Mexico and via ship in the form of liquified natural gas (LNG). The U.S. is on-track to be a net exporter of natural gas by 2020.

In just the last two weeks, the price of natural gas has increased by $0.45/mmbtu. The January, 2017 NYMEX contract, which will be the front month contract by late November, closed at $3.32/mmbtu on June 10th. The oil and gas prices you see quoted in the business news each day are the front month NYMEX contracts.

(Click to enlarge)

The reason for the sharp move in the gas price is awareness by the speculative traders that our gas market is going to be a lot tighter heading into next winter. U.S. production is now falling by over 400 MMcf per day month-after-month, primarily because the associated gas from horizontal wells in the oil shale plays is dropping like a rock. Gas from the Eagle Ford shale play in South Texas is falling by over 200 MMcf per day. At this rate of decline, we will have 4 to 5 Bcf per day less gas supply heading into the heating season than we had a year ago. Five percent less supply will have a significant impact on gas prices.

For reference, the U.S. consumed approximately 80 Bcf per day in 2015 (including exports). U.S. consumption is expected to be approximately 83 Bcf per day in 2016 and approaching 100 Bcf per day by 2020. Driving the increasing demand is power generation, LNG exports and industrial demand.

(Click to enlarge)

Five coal fired power plants and a nuclear power plant are being replaced by gas fired plants this year. Plus, the weather forecast for July is HOT for the eastern U.S., which will significantly increase demand from our gas fired power plants. Gas fired power plants now produce more electricity than coal fired power plants in the U.S.

Over 90 percent of new homes built in the U.S. are heated with natural gas, so residential space heating demand goes up each year.

Natural gas in storage is high for this time of year thanks to a mild winter, but a hot summer should bring storage levels back to normal by the time the next winter heating season begins. If that happens, the price of natural gas in the first quarter of 2017 should top $4.00/mmbtu.

Conclusion

The sharp decline in drilling activity has U.S. oil and gas production on steady decline and I expect the rate of decline to accelerate in the 3rd quarter. Related: Can Trump Change The Direction Of U.S. Energy?

This cycle has devastated the oilfield services firms, so it will take longer than expected to ramp up drilling & completion activity.

Wall Street fund managers have already started rotating money back into the energy sector. Although the risk-reward potential is compelling, investors should expect a lot of volatility in the sector. The large-caps are the safe bets because they have an advantage with better access to the capital markets. As the cycle “matures”, the well positioned small-caps should do quite well.

Upstream MLP have been hammered over the last two years and they may remain in the Wall Street “penalty box” for quite some time.

By Dan Steffens for Oilprice.com

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  • Brad on June 15 2016 said:
    Mr. Steffens;

    I agree with your point of view, but the prospects of higher oil prices may be EVEN BETTER than you predict!

    Case in point- You say "for those of you investing in upstream oil & gas companies it is important to note that "$70 is the new $100"........

    The fact is, the vast majority of upstream companies were 'losing' money at $100. There is no chance in hell that they will be more efficient (or profitable) at $70 ! The financing for the great U.S. shale oil expansion has mostly dried up, with this hindsight. That expected production upswing will just not happen.

    Oil prices will therefore balloon higher than many expect, with a steep contraction soon after. People can take advantage of this now, with the premise that the higher prices will be temporary, but very profitable for those that get in early and get out when the price is ridiculous!
  • jay on June 15 2016 said:
    What a good article. I agree with everything you mentioned except for $70 is the new $100. as for starting yes you are right but as more rigs come on and demand grows it will be back to the$100 price. The reason the oil companies have a much lower break even now compared to 2 years ago is not a result of increased rig technology or efficiency. It is a result of ALL services involved with actually drilling and completing the wells lowered there costs so significantly that they are no longer making any money. This will not continue when oil prices increase and many more rigs are needed.
  • Trey on June 16 2016 said:
    Sounds like someone is long and wrong. The problem is that there is a lot of misinformation. First this Asian crude demand is winding up on our shores as gasoline. Second, the three timely supply disruptions that have saved this ralley have yet to show up as significant stock reductions. Third, product demand is rolling over probably due to excessive prices or slowing growth. Fourth, the Chinese are about to top off their SPR. Fifth, all the contango Bulls who are storing the hidden glut off oil will be dumping very soon just like they did last year. Sixth, natural gas prices are a cold winter away from $5-$8. This is a game changer as these oil wells produce a lot of gas. Producers will add OIL rigs with sub $40 oil if they could fetch $5 natural gas. Seventh, this v like recovery is a pipe dream. We live in a free market now not one controlled by a cartel. Take a look at the open supply cuts to create the 2008 ralley. Eighth, brexit is likely to crash the global economy. Nineth, oil has to go lower or we will be in an awful position this time next year from an oil stocks position. The last thing we need is to max out storage. Tenth, don't be upset if someone sells your 2x$26 dollar oil before you do.
  • Edwin Redwood on June 16 2016 said:
    US Crude Oil is still venerable towards the downtrend $46 with an extension.
  • Muz on June 16 2016 said:
    Higher oil prices? You only wish!!!
  • Blind Squirrel on June 16 2016 said:
    Oil production will not fall hard in Q3 as this article predicts. Several producers have recently upped their 2016 production guidance because WTI has been near $50 versus initial predictions of about $40 for most of the year.

    Demand is not relentless as author says. In fact demand is sadly limited to gasoline - not shipping, not air travel, not haulage, not commercial. Ergo, the approaching end of driving season will soften demand for fuel. Cue softer oil prices in next few months, the opposite to what the author is calling.

    Author needs to learn more about the current market and not default to misplaced ideology which misleads investors.
  • Matt Biddick on June 16 2016 said:
    Trey, I think you're possibly wrong on your point #6. Natural gas production is the one type of production that can be turned up and down with the crank of a valve. There is a lot of natgas production that is shut-in/curtailed due to the low price environment. Can't see that price level for natgas at all.

    As for gasoline demand and the way that Blind Squirrel characterizes it, there is nothing sad about gasoline demand. You might check into the number of cars being sold in China and India my friend. Those folks are just like us. They don't like to walk/pedal when they want to get somewhere.
  • Rick Mattia on June 17 2016 said:
    This investigative report is mute....it's a big world out there and the market is flooded. Speculation will only harm the market right now.
  • Randy Peterson on June 19 2016 said:
    I believe Dan Steffens is right in his forecasting. One thing that I worry about is the price elasticity we could suffer if major projects are delayed for too long. How will we feel in light of current events if our SPR was depleted. Who would be willing to live without oil while new supplies from deepwater platforms take 10 years to build. Hillary will shut down fracking.
  • Vishwas on July 10 2016 said:
    The author seem biased. Oil peaking in future is most unlikely for a few very simple reasons. Electric cars fast replacing gasoline cars, small commercial EVs are expected soon, oil power plants are history (Bing replaced by Natural Gas plants) , battery tech reducing battery costs (down to 1/3 till now), unlikely spectacular economic growth prospects - and - as against this - crumbling oil economies need pumping more and more oil just for survival (i.e. cost of the force and subsidies to contain public anger who were used to free goodies), maintain the costly infra build in the past. 2-3 crumbling States can easily spoil oil cartel.

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