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

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.

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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.

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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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