There has been plenty of chatter on oil and gas price activity in recent months, and deservedly so. Crude oil prices haven’t been this low in 11 years and I have received a lot of calls from inquisitive readers. I am happy to hear that most readers are viewing this drop as an unprecedented opportunity to build exposure to the class, so I would like to take this opportunity to point out some market fundamentals, as I believe most of the talking heads are preferring sensationalism over common sense. Here are some key reasons why we believe oil prices will rebound.
1. Global Demand. When discussing oil, the first point I usually hear is that “global demand is down!” Usually someone utters the word “China,” which, for some reason, causes panic. Let me calm some fears. First off, global supply rates are expected to decline, NOT demand. The following metrics show the expected demand rates throughout 2017. Note that rates are not negative, implying that these regions are expected to consume more each year until 2017. For China specifically, the EIA estimates for 2015 that it would account for ¼ of the global oil consumption, and that its demand is expected to grow by 2.7% in 2016.
2. Inventory Levels are overflowing. This concern is also relevant, but is a timing issue. Many readers point out, and rightfully so, that oil and gas prices cannot rise with a glut of supply looming over the market. But is this supply imbalance overblown? At Sprott, we note that the operators and producers pulled back quickly in response to the price drop in 2015, perhaps too quickly. According to research conducted by Raymond James, in the big three oil producing regions in the U.S., both new supply has been cut, (we continue to see rig counts fall in the U.S) and legacy wells continue their inevitable decline. The net result of decreased new production and legacy production means that each month, starting around July 2015, less oil is being produced. While the following chart only shows production in the Bakken, Permian, and Eagle Ford, not total US production, the trend pervades across the U.S. We can imply from these charts that the US, and likely the rest of the world, are already beginning to eat into inventory levels to supply demand.
While this is a relatively short term view, there are longer term implications that may allow for sustained price growth over the coming years. Declining production means declining cash flows for the production companies. From a 30,000 foot view, this also means that these producers are unable to use these cash flows to grow their reserves (usually achieved through acquisition of other, producing fields, or through organic exploration growth). Should prices rebound quickly, new production may lag to meet the demand as investment has been stymied.
3. Credit lines are shrinking. While cash flows have declined, company’s access to credit has also been drastically been cut. Companies value their reserves on the basis of which barrels can beeconomically extracted. The oil is still there, but if it cannot be pumped out at a profit, it no longer is used in the reserve calculation. Since prices have dropped so drastically, so have reserves and in return, the borrowing base on which oil and gas companies can lend against has also begun to decline. With quarterly 10k’s being released, our own Jeff Howard at Sprott Global who has done oil and gas valuations since the early 80’s recently noted how severe these drops in reserves can be. For example, Anadarko Petroleum had a reserve value at the end of 2014 of $30.7 billion. At the end of 2015, the reserve value had dropped to a whopping $9.7 billion. Even more concerning, the net present value calculation used to determine those reserves used the average oil price in 2015 of $50.28/barrel. One can only imagine how severe the impact will be on Anadarko and other oil company’s ability to gain access to much needed lending facilities. With credit shrinking, the ability for oil and gas companies to increase or even maintain current production levels has been seriously hindered.
4. Rumored OPEC Production Cuts: It’s difficult to have a conversation on oil without mentioning OPEC. Thus far, OPEC has belied expectations, refusing to cut production rates in response to lower prices. But recent events in the past month, prove how much impact word from OPEC can be. A few weeks ago, OPEC members Saudi Arabia, Qatar and Venezuela along with Russia announced talks of a potential production freeze to January output levels. Though just words at this point (the meeting will be held in March), the mere announcement of the possible action drove oil prices up over 7 percent.[1] This causes me to remember how volatile these markets can be and how extreme moves can come from non-fundamental headline news. While we can never predict the timing, fundamentally, we believe oil is set to rebound.
While there are a myriad of other factors that weigh on commodities prices, we believe the above four (production declines, eroding inventory and credit levels, and global politics) are meaningful impacts. Global demand is expected to continue to grow, while production is on the decline. Inventory levels remain at least part of the timing question, as new and conflicting reports emerge every day. The market is certainly in flux, and therein lies our opportunity. It is important to take a long standing view, as short term fluctuations won’t have a meaningful impact on your portfolio. Do you believe that oil will remain at $35 per barrel throughout the year? Perhaps. Do you believe it will remain at these levels for the next three or five years? Fundamentally, we do not.
If you have questions about this article, please contact your Sprott Global broker or the author, Mishka vom Dorp at 760-444-5254 or through email at MVomDorp@sprottglobal.com.
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