14 months ago, much of the investment world was still wondering whether or not oil prices would see a sharp, quick recovery. My investment at the time discounted that possibility, and my presumption has been shown to be correct so far. Today, some analysts are still looking for less dramatic, but still very substantial recovery in a matter of months. This article will look at what’s changed about the oil market and why that’s probably an unreasonable expectation, particularly with respect to WTI (West Texas Intermediate) oil prices as tracked by The United States 12 Month Oil ETF (NYSEARCA:USL).
- U.S. is the new swing producer: In terms of production, fracking only really began to hit its stride around 2012. Today, fracking accounts for more than half of domestic production. Its main strength compared to conventional production is that it can be ramped up much more quickly. That coupled with the retraction of the ban on U.S. oil exports means that OPEC can no longer dominate the price of oil.
- Boosted production: The shift in competitive roles means that OPEC and other traditional (and generally more efficient) producers can no longer effectively cut production while maintaining revenue. That’s why OPEC has consistently maintained or increased production, even as it projects moderated pricing.
- Demand is uncertain: The rise of renewable energy in conjunction with pollution and climate change initiatives makes increasing long-term demand for oil highly questionable, especially if it comes at a high price. The push towards electric vehicles and drone delivery is just a facet of this trend. Natural gas vehicles have had a foothold in Europe for a long time and, as LNG facilities continue to be built out, their viability should expand.
- Technology is making production cheaper: The transition of oil towards being a truly competitive and more quickly responsive market is enabling previously sidelined technology providers to optimize production costs. The related investment opportunity that I highlighted, which should begin to hit the market next year, has the potential to reduce production costs by $4-5 per barrel on its own.
Back to the Argument (and Its Shortcomings)
The basis of the argument for an oil rebound is that investment in production has fallen along with prices. What it misses is the overhang from the recent boom. As contracts leftover from recent boom years were fulfilled, the inventory of DUCs (drilled but uncompleted wells) has risen to historic levels. This has resulted in a surplus of DUCs, which would cushion any temporary shortfall in production while new production is brought online.
Furthermore, an analyst note cites a drop in North Dakota production. Because of an impending tax change in Oklahoma, where the production tax will jump from 1% to 7% over the next two years, most other areas of the U.S. have seen a drop in production. Specifically, horizontal wells drilled before July 1, 2015, are taxed at 1 percent for four years and 7 percent thereafter. Under a new rate formula enacted two years ago, all wells drilled after July 1, 2015, are taxed at 2 percent for three years, then jump to 7 percent after that. This is mostly unrecognized in the investment community, but it skews both the cited North Dakota production and the short-term price of natural gas, since Oklahoma generally has a gassier mix of resources. What’s more, U.S. rig counts have already risen for seven weeks running; the associated production just isn’t flowing into the books yet.
What the Markets are Telling Us
- Short Term: The most recent bump upwards has been fueled by renewed speculation on a production freeze. I see this as akin to the FOMC jawboning about interest rate increases as a means of managing the market. It’s also been theorized that the jump in WTI was further enhanced by hedging in financial markets, as traders cover their exposure after realizing that fundamentals don’t support the speculation. That in turn magnifies a potential a recoil for USL.
- Medium Term: Actually, I see the chances of a post-election interest rate increase by the Fed as far outweighing the chances of a production freeze, and I’m not the only one. Such a move would strengthen the dollar, thereby further weakening the price of oil. A Clinton win, which seems most likely at this point, would also further strengthen the outlook for renewables, while decreasing medium-term domestic demand projections. By contrast, a Trump win constitutes a (fading) risk factor here, due to his pro-oil policies.
- Long Term: I think the most lasting lesson can be learned from the oil market itself. Although the market has crashed over the prior two years, prices over the past year have looked more stable. Despite that, my private analysis of WTI spot prices from the EIA as compared to the 12-month futures as tracked by USL shows that the ratio of the former to the latter has risen consistently to around 2.6 versus a historical range of 2 to 2.25. The ratio indicates that demand for future oil is less than at present, which is somewhat normal during summer. In fact, it’s easy to see a seasonal high, like the one we’re experiencing now, in each of the past three years. However, the extremity of the ratio is almost unprecedented. The closest we came was in 2012 and 2014, before the dramatic downturn in oil prices.
Although market data is often indicative, it shouldn’t be taken as destiny. It’s a good picture of where things are headed, but that can always be overruled by surprises in the real world. For instance, it’s easy to imagine the current environment destabilizing the Middle East, which could quickly reverse oil’s fortunes. We’ve already seen that to some extent with Venezuela, but I think that, with regard to limited disruption, the spread between Brent and WTI is instructive. It dropped to almost nothing following the repeal of the U.S. export ban, but has since widened back to over $2 per barrel. This is still lower than the $5 norm during the ban, and seems to indicate limited global appetite for new or backup resources.
Thus, barring epic geopolitical disruption that would escalate most people’s concerns beyond the financial realm, I see oil as having entered a new low to mid-double-digit normal that will feature increased seasonality, which will gradually be smoothed by increased predictability. In the meantime, this makes futures ETFs like USL somewhat riskier even than many of the better oil companies like Chevron (NYSE:CVX), which has an impressive natural gas portfolio, not to mention a dividend. I note that average 2016 WTI spot prices have been 20% lower than 2015, whereas the average close price for USL has been 35% lower.
Over the short to medium term, this outlook should be reinforced by hidden oversupply from frackers and more competitive renewable sources. Deployment of such techniques outside the U.S. could further enhance flexibility and, as the longevity of the new pricing regime becomes clearer, oil super-majors will regain confidence to develop longer-term assets, which are more cost effective. In the meantime, shifts in regulation and lagging technology deployment are masking the first steps in the rise of natural gas a bridge fuel on the way to renewable energy.
I think the time is finally coming when investors who can correctly anticipate these transitions while avoiding the pitfalls will be able to achieve massive returns. Hydrocarbons will have their place in our world for the foreseeable future, but I think oil bulls looking for a rebound anywhere near inflation adjusted triple-digit prices in the coming years are very mistaken. Their analysis tends to look at trailing data that is becoming increasingly irrelevant to a reconstituted market. While these companies have represented safe havens for investors in the past, they are looking increasingly like mighty dinosaurs stuck in the tar pits. I may not live to see the end of their species, but their time is surely passing.
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