“These are the times that try men’s souls.”
                                                — Thomas Paine

It certainly isn’t easy being an energy investor these days, unless your portfolio is heavily weighted with refiners and solar companies. If that’s the case, congratulations. If instead you’ve loaded up on drillers and MLPs, this recent period may bring to mind Thomas Paine’s famous quote.

But we take the long view here, and today I want to put things into a bit of perspective. The long view for oil still looks pretty positive for reasons I will cover today — but the short term is likely to continue to be choppy.

The Statistical Review of World Energy 2014 released recently by BP (NYSE: BP) contains a plethora of oil production and consumption statistics that support a bullish long-term view.

Let’s start with the evolution of U.S. oil production in recent years. Since the shale oil boom really got underway in 2008, no country has increased oil production faster than the U.S. Production accelerated in each of the past three years, annually setting 3 consecutive records for the biggest increase in oil output:


In fact, per the BP Statistical Review, U.S. oil production reached an all-time high in 2014, and leapfrogged Russia and Saudi Arabia into first place globally:


As I explained in the last Energy Letter, that’s partially because the Statistical Review includes natural gas liquids (NGL) in its definition of oil. The U.S. has seen a surge of NGL production as a result of the shale gas boom, and this has contributed to the surge of U.S. oil production. Nevertheless, most of the increase has indeed come from crude oil, and it is hard to overstate the global importance of the new crude supply that came online in the U.S. Perhaps this graphic will help put it into perspective:


Over the past decade, global oil production increased by 7.7 million barrels per day (bpd). U.S. production increased over that time span by 4.4 million bpd, or 57% of the global total. If we look at just the past six years, U.S. production growth is equivalent to 83% of the global supply added during that time. (Countries that had declines in oil production are not shown, which is why the increases shown on the chart add up to more than the global total.)

Not only did U.S. oil production grow faster than production in Saudi Arabia and Russia, but it outpaced production growth in all of OPEC, as well as the entire Middle East. Thus, the $100/bbl oil prices that we experienced in recent years could have been even worse (and still in place) without U.S. shale oil production.

Oil bulls need look no further than demand growth for additional support. While we tend to have a Western-centric view of the world — and thus may end up with the impression that oil demand is declining — the truth is quite different:


Global oil consumption increased by an average of 900,000 bpd annually over the last decade, rising in 18 of the past 20 years. If we look back 30 years, global oil consumption increased by an average of 1.1 million bpd annually. (Note that BP’s demand numbers for oil include biofuels, and are therefore larger than the production volumes it tracks.)

Demand did decline in member countries of the Organisation for Economic Co-operation and Development (OECD) — the grouping of the world’s developed countries. But demand growth in developing countries overwhelmed the declines in the developed world. In just the past five years, demand in developing countries has increased by an average of 1.6 million bpd annually.

Aggregate developing world demand has now surpassed that in the developed world. And note that there was hardly any negative impact on demand in developing countries even with oil prices at $100/bbl.


Once upon a time I had a view that as oil prices increased, poor countries would be priced out of the market. I began to change my mind in 2008 when I took a business trip to India and saw a motorcycle carrying seven people. My epiphany was that people in developing countries use so little oil per capita that small changes in consumption don’t make a big dent in their budget. But they can have a large effect on lifestyle. What would it cost seven people to ride a motorcycle 20 miles? If gasoline is $2/gallon and the motorcycle gets 60 miles per gallon, then the cost per rider would be less than 10 cents. Double the cost of gasoline, and the per-rider cost increases to 20 cents. But for that price they are traveling 20 miles in 20 or 30 minutes — a journey that would take them hours to travel on foot. And, typically, the poorest countries have tended to see the fastest growth in per-capita incomes.

This, in a nutshell, is why developing world demand has thus far proven largely impervious to rising oil prices. What is driving consumption in these countries is a very large number of people using just a little bit more oil than they did before. High oil prices will do little to dissuade them from buying a little bit more when it can make such a big impact on their lives, especially when incomes are rising.

In the West, we have much higher per capita consumption, much more discretionary consumption and a lot less relative income growth. We depend on oil to make our lives easier, but we also have a lot of non-essential consumption that can be reduced as the price rises. Thus, developed countries saw a demand response as oil prices rose to $100/bbl, but developing countries did not. And the consumption growth in developing countries far surpassed the declines elsewhere.

Here is the point I want to drive home to long-term investors: There is still no viable long-term alternative to oil — and there  wouldn’t be one even if crude appreciated to $150/bbl. Electric cars will continue to make small inroads, and yes, we would likely see more demand declines in the West if oil prices rise to that level. Biofuels have displaced some oil demand over the past decade, but it’s a contribution that is unlikely to be repeated over the next 10 years.

Do you know what is likely to be repeated over the next decade? Global demand growth for oil. The International Energy Agency recently forecast that global demand will increase by 1.4 million barrels per day this year, and a further 1.2 million bpd in 2016. The bulk of that demand growth is expected to come from developing countries in Asia.

Note that over the past 50 years, there is no 10-year period in which global oil demand declined. The closest would be the stretch from 1979 to 1989, which featured the Iranian Revolution, the Iran/Iraq war, spiking oil prices and a deep U.S. recession. Nevertheless, following a four-year decline, global oil demand grew at the fairly steady rate, adding an average of more than a million barrels per day each year for the next 25 years.


Thus it’s a pretty good bet that demand will grow over the next decade. But what about supply? Yes, Iran may be putting another half million barrels per day on the export market over the next year. However, I would note that in 2014 Iranian oil production was only 2% off the all-time high set in 2013, and oil production in Iran has historically grown slowly. What if a year from now Iran’s half million barrels per day are on the market, but oil demand has risen by another 1.3 million barrels?

It won’t take long for the world to absorb Iran’s exports and the current glut of stored crude. Where, then, will the rest of the oil come from? U.S. shale oil production is going to stall out with prices below $60/bbl. And the rest of the world is not adding oil supply fast enough to keep up with likely demand growth. That is a recipe for higher prices, which will ultimately lead to a rebound of the U.S. shale oil and gas industry.

How long will it take for oil prices to recover? It could take a year. Again, this is why we take the long view. The fundamentals favor a recovery of oil prices. As I said earlier in the year, $40/bbl oil is not sustainable. Neither is $50/bbl oil. The world is going to need higher prices if supplies are to keep pace. We do find ourselves in a glut at the moment, but these low prices will cure that over time.

So what’s an investor to do? A long-term investor should probably be shifting money into the sector. This is the time to do it. I would not wait until prices have rebounded back to $60/bbl. You may have to wait a year or two to see prices recover. But they will recover.

For shorter-term investors, the picture isn’t as simple. Will oil prices be higher or lower in six months? Right now it’s very hard to say. The bearish news of Iran’s exports will hang over the market for a while. High crude oil inventories need to start coming down. Barring any Black Swans, there isn’t a lot likely to drive oil prices higher for at least several months. Short-term investors will likely find more opportunity in the refiners we have recommended this year, as they still have some room to run.

Of course there are a lot of oil and gas companies that are in financial trouble, and the longer it takes to recover the more likely they are to go bankrupt or be taken over.

Who are the strongest and weakest players? A report recently released by Goldman Sachs speculated on the likeliest acquisition candidates among exploration and production companies.   

Of note, there are several portfolio stocks listed. Those in the upper left of the graphic are among the most financially sound with good assets. They include Growth Portfolio mainstays EOG Resources (NYSE: EOG) and Cabot Oil and Gas (NYSE: COG). I would also include Conservative Portfolio holding ConocoPhillips (NYSE: COP) in that group.

Goldman believes Cabot is ripe for picking by a supermajor because it has great assets, is undervalued by just about every measure, and with an enterprise value (EV) of $13.6 billion wouldn’t be too big a bite for Chevron (NYSE: CVX) or ExxonMobil (NYSE: XOM). EOG is the most solid of the bunch, but its $47 billion EV would be harder to swallow.

Conclusions

These are certainly trying times for energy investors. That last time the market felt this bad was the one-year period beginning mid-2008 when oil prices began to crash. At this year’s Wealth Summit in Denver, I shared a slide that is apropos today. It is the 10-year performance of my energy-heavy 401K over the past 10 years (with the starting value normalized to $100,000):

Note that between about May 2008 and February 2009 my portfolio was nearly cut in half. Of course it wasn’t just energy stocks; the stock market got hit hard across the board. But I stayed the course because I believed oil prices had fallen to unsustainable levels. In fact, I doubled down in December 2008 and invested more in the sector. You can see the result. Yes, it took a couple of years to recover from that beating, but I am a 10-year window sort of guy. And despite that volatility, that’s a performance I can ultimately live with.  

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