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Forget The Pullbacks – Oil To See Strong Rebound In 2017

Oil refinery

August 11, 2016 may be the point in this oil price cycle that will mark the start of a sustained increase in crude oil prices. That’s the date that the International Energy Agency (IEA) published their forecast that demand for oil would exceed supply in the 3rd quarter. Shortly after the IEA’s Oil Market Report came out, the Saudi Energy Minister Khalid al-Falih said the kingdom would work with other producers to stabilize the market. Tighter supply and OPEC willing to curb production growth is a recipe for higher oil prices.

 

When you step back and look at a longer time frame, it is clear that this oil price cycle which started in mid-2014 bottomed in February, 2016. The most recent pullback that started late in June and continued through early August was just the speculators overplaying their hand on the short side. The brief dip below $40/bbl did not get close to the double-bottom in February.

Remember what oil prices have never moved up or down for an extended period of time. There are going to be many pullbacks along the way to a more sustainable price level for oil. I believe that oil will settle in the $60-$70 range sometime in 2017.

During the first week of August, 2016, speculative NYMEX short crude oil positions reached the highest level in at least the past ten years. Since the IEA report came out on August 11th the shorts have been scrambling to cover their positions.

 

(Click to enlarge)

Speculators Set the Price of Oil: The “paper” oil barrel market is much bigger than the “physical” oil market. In fact, the average volume of West Texas Intermediate (WTI) oil contracts traded daily on NYMEX and other commodity trading floors is over 100x the physical amount of WTI and over 5x the global oil supply. Speculators can often temporarily overwhelm the longer-term supply/demand fundamentals, creating volatile short-term oil price swings. When the speculators get blindsided by a change in what is happening in the “real world”, they can get burned. Related: The Permian Pitfall: A Race To The Bottom For Tight Oil

• An historically high short position for WTI is bullish for oil prices
• A falling U.S.Dollar Index (DXY) also supports higher oil prices

During the first week of August, 2016, speculative NYMEX short crude oil positions reached the highest level in the past ten years. Since the IEA report came out on August 11th, the shorts have been scrambling to cover their positions. They are having a hard time finding enough sellers willing to cover their positions at these low prices.

 

(Click to enlarge)

The fundamentals also are supportive of oil prices. Non-OPEC production is on steady decline. Demand growth is relentless, moving up more than a million barrels per day each year. This world will soon be consuming over 100,000,000 barrels of hydrocarbon based liquid fuels and feedstock daily. It is clear that the price of oil cannot stay under $50/Bbl much longer because producers cannot meet demand at that price.

OPEC only supplies about 40% of global oil demand. Outside of the Middle East there are only a few places where oil reserves can be developed profitably for under $50/Bbl. We are lucky to have a few of them in the United States.

How to profit from a shift in oil prices

On August 16th the chief commodity strategist at Merrill Lynch moved the energy sector from “market weight” to “overweight”, predicting the sector would outperform the S&P 500. Merrill Lynch estimates that WTI will rally to $54/bbl by the end of this year and $69/bbl by next June.

“Oil production continues to fall as global oil & gas investment has been cut by nearly $300 Billion (41%) and active rig counts have dropped by 37% since the 2014 peak. In contrast, low oil prices continue to drive healthy demand growth, putting the oil market on pace to see its biggest supply-demand deficit since 2011. Our commodities team estimates that the (supply) deficit will last through 2020. Historically, when oil has rallied over 25%, Energy has outperformed the market nearly 90% of the time, with average outperformance of 11%.” – Merrill Lynch

During the first six months of this year, the energy sector’s weighting in the S&P 500 dipped below 7%. There has never been a time when the energy sector’s weight has dropped below 7% and the sector did not outperform the market over the subsequent three years. This is not going to be the first time it happens. Related: Russia-Iran-Turkey Alliance Could Change Energy Dynamics For Good

Raymond James is still predicting that WTI will average $80/bbl in 2017. I am not quite that bullish, but it is clear the view from Wall Street has changed and investors will be wise to add more energy to their portfolios. The upstream oil & gas companies will get the most impact from higher oil prices. Rising natural gas and NGL prices are also increasing upstream revenues.

Oilfield services firms will need a sustained period of increasing capital expenditures by the upstream companies before they can regain the pricing power they’ve lost. I believe oil must be over $60/bbl for several months before we see a significant increase in drilling activity.

If you decide to add more exposure to oil to your portfolio, I suggest you stick with companies focused primarily on the two areas in the U.S. where profits can still be generated even if oil stays at $40/bbl. The two best oil plays in North America are the Permian Basin in West Texas and SCOOP / STACK in Central Oklahoma. I follow over fifty upstream companies and well results in these two areas are getting better each quarter.

Don’t put all your eggs in one basket and stick with companies that generated solid cash flow from operations during the first half of 2016. This is an extremely capital intensive business, so make sure they have a strong base of proven reserves, a lot of running room in inventory (development drilling locations), and the liquidity needed to fund their drilling programs. Keep in mind that good leasehold positions have little value if the companies don’t have the capital to develop them.

If Merrill Lynch is right about oil prices, “a rising tide will lift all boats”, but owning profitable companies with valuable assets in the nation’s best oil plays should give you a leg up on the market.

By Dan Steffens for Oilprice.com

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  • Jay stevens on August 23 2016 said:
    Keep dreaming Dan! Oil will be $10 by 2019.
  • S K on August 23 2016 said:
    Thanks for your thoughts Jay Stevens. I am not sure that I am as optimistic. I think 2018 MAY show some increases. Schlumberger just reduced headcount and posted losses Q2 2013. There is an oil glut at the moment. The commercial oil environment speaks in terms of quarters. We are mid-Q3 2016. The Summer season will end and oil prices likely reduce mid-September affecting Q4 & Q1 2017 projects. So, a steep increase in oil prices would likely promote activity for Q2 2017. Figure 3-6 month lag on any major project spending even after an increase. So, if there is a rally in 2017 - very iffy - it needs to be sustained to promote bringing jobs back and new projects.
  • S K on August 23 2016 said:
    I meant to compliment the author, Dan Steffens. No offense Jay Stevens.
  • Mike on August 23 2016 said:
    Jay s. were you high when you posted that comment? Prices will be around $40-70 by 2020.
  • Etin on August 24 2016 said:
    Oh, Dan. I hope folks don't load up on energy stocks on the basis of this article. Dream on.
  • Jim on August 24 2016 said:
    Dan - It only takes a nameless yahoo from Saudi Arabia to speak 20 words and the market is 'talked up' for 2 days. I agree with Etin. Hope nobody takes actual action on this million to one shot.
  • moshe on August 24 2016 said:
    Oil generally $ 200 a barrel
  • Brian on August 24 2016 said:
    S K not sure where you heard that about Schlumberger, my wife worked for them and was laid off last spring, but they just called her and many others back. They are staffing up if that means anything it means production is coming back and there is only one reason for that and that is they suspect a price increase.
  • John Brown on August 25 2016 said:
    I read articles like these, and look at the massive collusion and corruption in how oil prices are managed and just turn away in disgust. The world currently has a massive glut of oil. Tankers are still sitting at sea storing it instead of delivering it, rail cars are sitting full of oil storing instead of delivering it, and we all know that despite some lower price driven declines there is more supply itching to come onto the market.
    Yet as prices fell a few weeks ago to $40 a barrel suddenly Saudi Arabia and Russia announce talks about freezing production, and others start talking the price up, and before you know it prices are edging up toward $50 based on nothing but everybody in the industry talking them up. There is no reason for the price of oil to be over $30 a barrel based on supply and demand. Why would prices settle into a $60 to $70 range when we all know at $50 supply in the USA will begin to recover, and the industry still acts like this is 1950 when it could take years to ramp up supply. New technology and lower cost price points mean that new supply from fracking in the USA can ramp up in months rather than years. At the very best if the glut of oil and gas available today actually does diminish $60 to $70 would be a price spike, not where prices are likely to settle. That is if supply and demand actually set the price. Its not OPEC driving oil prices upward its the entire industry desperately colluding to do it.
  • Andrew on August 26 2016 said:
    Good job, finally someone writing with a little bit of common since.
    I work in the oil field and Wall Street doesn't know crap from Wildhoney when it comes to Oil production numbers. We've seen 70% declines all through the south. That includes Texas Louisiana and Oklahoma. Fields that were typically making 10,000 barrels per day are making 3000 barrels per day and 80% water that needs disposal. And guess what all future projects for drilling have lost their budgets. Even if you brought in drilling rigs right now it would be a year or two before those numbers could even reach 7000 barrels per day.
    But hey what do I know?
  • Rob Levesque on August 28 2016 said:
    $10? lol Jay Stevens...
    The barrel itself is worth more
  • CLINT LInder on August 28 2016 said:
    It seems to me the buyers who produce fuels and other crude based products would be buying the cheap crude and storing it at the lower price. If you are selling hamburgers and the price of ground meat drops to $0.50 a Lb. I'd think the company making hamburgers buys another freezer and loads it up while the price is low. With the price of oil as low as it has been, and if forecast keeps it low for the coming future, if I owned a refinery I'd be building tank farms.
  • Kantor on October 12 2016 said:
    I've made quite a discovery. Oil prices can be easily regulated by global heavy weights, sort of the USA or the EU, by introducing sanctions like it was done with Iran, one of the major oil producers. I guess sanctions should be declared a taboo, for it has little to do with democracy. I also wonder if the United States, now also one of biggest shale gas suppliers, may be also subject to similar sanctions on initiative of China, say, or some other country heavily interested in higher of lower prices on gas. Experts assert that oil prices will go up in 2017. How can it affect EU countries?

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