Introduction

I didn’t plan to write about oil this week, but given the volatility in the markets it is perhaps a good time to take stock of the situation. My goal is to convince investors not to panic and to explain why those predicting oil prices as low as $10 or $15 a barrel are off the mark.  

The price of West Texas Intermediate (WTI) crude briefly dropped below $40 a barrel (bbl) again last week after flirting with that mark twice previously this year. This persistent weakness has many oil and gas investors wondering whether this is the dawn of a new era of cheap oil. Some are calling for much lower oil prices in an echo of the bearish calls at the prior lows.

Predictions as low as $10/bbl were made by prominent money managers. Instead, the price of oil went to $60, and those predicting ultra-low prices went quiet for a while. So where are we headed from here? Do oil prices have further to fall? Or are they unsustainably low, creating a buying opportunity? I will explain the major drivers behind both views today.

Short-Term Noise

First, let me explain my general view on oil prices, which are shaped by factors both short-term and long-term. The short-term ones are unpredictable; they can make oil prices move down when they are fundamentally undervalued, or jack them up on a similarly thin pretext..

This happened the week before last when the market got spooked by an unexpected increase in reported U.S. crude oil inventories — which had been declining since April. That pushed the WTI below $40/bbl — something I did not believe we would see this year. Short-term influences like these do not have a lasting effect on oil prices, and as a result they don’t factor much into my oil price projections.

If you are a short-term trader, then of course you have to pay very close attention to things like the weather (is there a hurricane moving into the Gulf of Mexico?), inventories (was there a surprise build or decline?), and refinery utilization (did some capacity unexpectedly go offline?)

But it’s challenging to invest on the basis of short-term, unpredictable factors. Thus, my projections are based on long-term fundamentals. It’s also why I stress that I am a long-term investor. I don’t much care about what oil prices are at a moment in time, I care about the average over the course of months and years. The only decision-making that I base on short-term factors are that on a dip I might buy an otherwise undervalued stock at an earlier point than planned, or on a spike I might promptly sell one that had become fully valued.

When deciding to move money in and out of the oil or gas sector, the foremost question is “Do I believe the current price of the underlying commodity is fundamentally undervalued or do I believe it is overvalued?” If I believe it to be undervalued, then I focus on companies with strong underlying fundamentals. If I believe it is overvalued, then I will obviously be more cautious.

So the main question for me is whether $40/bbl is a sustainable price for WTI crude.

The High and Low Price Cases

How could people have widely divergent views on the price of oil? Let me try to lay out their reasons. Let’s call the bear case that which has oil prices averaging $30/bbl in one to three years, and the bull case one that assumes an average price above $60/bbl over the same time frame.

The bear case for oil is one in which record U.S. production continues to increase at current prices. Or perhaps, as I heard suggested recently, “abundant low cost reserves will soon be available from Iraq, Iran, Kuwait and Venezuela.” (Never mind that most of Venezuela’s heavy crude is produced expensively.)

The bears also believe that demand for oil is slowing, driven by the economic struggles of China, and possibly that renewables are poised to take more and more market share away from petroleum. Finally, many bears believe that growing crude oil inventories must inevitably lead to falling prices.

The bull case holds that $40 is an insufficient price to meet growing world demand, and that capital spending cuts that began when oil was still above $50 are already crimping production. Low prices also tend to spur demand, with the International Energy Agency noting recently that “global oil demand is rising at its fastest rate in five years in 2015.”

This combination of factors will inevitably drive up oil prices as shrinking supply fails to meet  growing demand. Bulls also believe that investors anticipate such changes before they are fully manifested, and will bid up the price of oil long before the stockpiled glut is drained.  

Which case has more support? It is true that, at this moment in time and for a little bit longer, we have an oversupply of crude. That is why oil prices are where they are. But I am not so much interested in a point in time as I am in the longer-term trends like the average price of oil over the next three to five years.

And I am solidly in the camp that doesn’t believe today’s prices can be sustained much longer. I have laid out the reasons why previously, but this may be a good time to review given the conflicting predictions for the direction of the oil market.

The Demand Picture

It all boils down to supply and demand. First, let’s discuss the trends in crude oil demand. Over just the past decade global oil consumption increased by an average of 900,000 barrels per day (bpd) each year, advancing 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.


Where is this demand coming from? Developing countries. 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, and now exceeds OECD demand.

Note that developing (non-OECD) nations’ demand growth is nearly impervious to high oil prices. That’s because this demand is being driven by a very large number of people consuming very little oil for now, on average. Using just a bit more can greatly improve their quality of life, disproportionately so relative to the incremental cost of the extra fuel.

Global demand for crude oil is projected to continue growing. The International Energy Agency recently forecast that demand will increase by 1.6 million bpd this year, and a further 1.4 million bpd in 2016. The bulk of that demand growth is expected to come from developing countries in Asia.

But what about China? Won’t China’s economic woes cause a decline in demand in developing countries? A friend recently posed this question to me, noting that China was responsible for 50% of global oil demand growth over the past decade.

It’s true that between 2004 and 2014, China was responsible for 4.3 million bpd of the 9 million bpd in cumulative demand growth, accounting for 48% of the total. But total non-OECD demand grew by 13.6 million bpd, so 9.3 million bpd of developing country growth — more than twice China’s demand growth — took place outside China. So while a slowdown in China’s growth might slow global growth in oil demand, but it certainly wouldn’t be enough to stall it, much less cause it to decline. Too many other countries like India, Malaysia, Singapore, Thailand, Vietnam, Indonesia, South Africa, Saudi Arabia, Brazil, Argentina and Columbia are all rapidly increasing their consumption of oil.

The Supply Picture

So it’s a pretty good bet that oil demand is going to continue to grow. Where will the world get the oil? Let’s look back at the last six years. I previously showed these slides going back 10 years, but the effect is even more prominent if we look back just six years to the beginning of the shale oil boom:


Since 2008, U.S. oil production growth is equivalent to 83% of the global supply added during that time. (Some countries had declines in oil production, which is why the increases shown on the chart add up to more than the global total.) U.S. oil production increased more than the combined output of Saudi Arabia, Russia, all of OPEC, and the entire Middle East. Yet even with U.S. shale oil production covering most of the new demand, oil prices exceeded $100/bbl. And while shale oil producers have been getting more efficient, they aren’t going to invest in new production at current prices.

As a result, U.S. crude oil production has started to fall. The Energy Information Administration (EIA) reported in its most recent Short Term Energy Outlook (STEO) that U.S. output declined by 100,000 bpd in July compared with June, and the EIA expects these declines to continue because of the steep cuts shale oil producers have made to their budgets. The agency reduced its forecast for next year’s U.S. oil production to 400,000 bpd less than this year.

Canadian oil producers are in an even deeper hole than their U.S. rivals. A recent article noted that at $40/bbl WTI Canada’s largest synthetic crude project is losing about $10 on every barrel. How long do you suppose that can continue? The larger producers will hang in as long as they can, but some of the smaller guys are going to be shutting in production at $40 WTI (which implies an even lower price for them because of the greater distances to markets). That will reduce imports from Canada — the very imports that have been contributing to surging crude inventories in the U.S.

If the IEA projections are correct, the world will need another 1.5 million bpd of oil over the next year. Shale, which has been satisfying most of the world’s oil thirst over the past six years, is beginning to decline at current prices. So that shortfall will need to be made up as well, in addition to the roughly 4.5 million bpd lost each year simply as a result of field depletion. Iran will add some oil to the mix, but it can’t come close to bridging this gap.

The handwriting is on the wall. Global oil demand can’t be met with $40 oil. The price has to rise. The longer the price remains low, the higher we are likely to overshoot to the high side when prices begin to rise. The only real question in my mind is how long does it take the market to recognize the shortfall that is being set up?

The OPEC Wildcard

This scenario presumes that OPEC doesn’t modify its current strategy. Recall that in late November 2014 the oil exporters’ club decided to defend market share instead of reducing production quotas to prop up the price of crude, as some expected. OPEC’s rationale was that such a move would only help shale oil producers grow their market share by allowing them to maintain high margins. Instead OPEC decided to produce all out, and the drop in oil prices that began in the summer accelerated following that meeting.

In June, OPEC once more decided to leave production unchanged. But this strategy is inflicting a lot of pain on OPEC countries, and many are becoming more vocal about the issue. This week Algeria wrote a letter to OPEC questioning the wisdom of the current strategy. The letter asked OPEC to consider taking some form of action to bolster oil prices, as many OPEC countries need oil prices at $100/bbl or more to balance their budgets. CNN recently reported that this year Saudi Arabia alone has burned through $62 billion of its cash reserves. By my calculations, the steep slide in the price of oil has cost Saudi Arabia some $200 billion in the past year.

I think the Saudis made a monumental miscalculation. While I have seen some claim that the rise of shale oil has effectively neutered OPEC, keep in mind that the organization still produced 41% of the world’s oil last year, accounting for 36.6 million bpd of global supply. Had OPEC decided to cut its exports by 5% or so last fall members would have lost some market share and, yes, the shale oil producers would have kept growing production. But oil prices would probably be at least twice what they are now. The net outcome for OPEC, despite the loss of market share, would have been much higher revenue than what its members ended up with.

Despite the internal disagreements within OPEC, Saudi Arabia may feel the need to save face. To announce an emergency cut to the quotas now, or even at OPEC’s next meeting in December, would be to admit defeat. The Saudis may argue that if they can hold out just a bit longer, they can set the shale oil industry back by years, and then when prices go back up OPEC will be the biggest beneficiary.

Conclusions

At the beginning of 2014, I felt like $100/bbl was too much for oil. In fact, I predicted oil prices would fall in 2014. (They stubbornly refused to until mid-summer). To be clear, I didn’t believe prices would plummet to $40/bbl, just that at $100/bbl supplies were outpacing demand. It took longer than I thought for the price to fall, but then it responded in a big way.

But now I believe the pendulum has swung back too far in the other direction. Forty dollars per barrel is simply an inadequate price to satisfy global crude demand that is rising by over a million bpd each year. Whether the price drops further in the short term is an open question, as the oil markets are notorious for overshooting. But the patient, informed investor will reap rewards by beginning to stalk bargains at these prices.

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