New York (KWR) December 21, 2015 - Looking into 2016, expect oil price to remain pressured as commodity and capital markets continue to slowly absorb surplus production and large unknowns overhanging the market are played out - most notably the impact of Iranian production and large global inventories. Currently, US independent refiners and petrochemical names offer compelling investment opportunities. Refiners are profiting from access to large, stable flows of low cost oil and despite several years of solid growth and valuations still do not reflect the new sector normal. Petrochemicals are facing the same dynamic, however it is low cost gas that is driving their comparative advantage and profitability. Longer-term, tight oil (shale) focused producers will become increasingly attractive as production and profitability rises with increased shale production in the wake of depleting conventional resources.
The steady decline in oil prices that began in the summer of 2014 is a result of three factors. These include (i) increased global oil supply driven by US tight oil production, the so called "shale revolution" that resulted in a 4.6MM barrel a day (b/d) increase in production from 2008 to peak 2105 levels, (ii) a slowing global economy, most importantly within China and the other emerging markets and (iii) OPEC's refusal to cut production as it fights to maintain market share.
Following continued price weakness into the end of 2014, analysts had forecast a recovery in crude prices to the $50bbl level in the second half of 2015. This was seen as a function of continued declines in US rig count and large, near universal cuts to FY15 capital spending budgets decreasing supply. On the other side of the supply equation, low prices were seen stimulating incremental demand. Adding validity to a back half price recovery thesis was general skepticism around OPEC's ability to adhere to a market share strategy given its dependence on oil revenues. Notable, as it is the de-facto leader of OPEC, Saudi Arabia had been viewed as a country that couldn't function in a low oil price environment for a protracted period, given its need to fund large social welfare programs seen after the "Arab Spring".
As we enter the final weeks of 2015, the oil market bares little semblance to forecasts. Oil is trading in the mid $30bbl range - having breached $35bbl, a seven year low - and global oil inventories are approaching record levels. As a result of front loaded production curves, decreased service costs and gains in well efficiency - and despite a 62% decline in the working rig count - US average daily production is on track to increase 9% to 9.3MM b/d in 2015. While a supply response is underway, production has proved more resilient than initially thought and further cuts in the rig count and time is needed before the market will see meaningful declines in US shale production.
The crude market is always one geopolitical event away from a spike. Based on current market fundamentals, negative investor sentiment and several unknowns overhanging the market, oil prices will remain pressured in 2016. Currently, the global oil market is oversupplied by 1.5MM to 2MM bb/d according to EIA and IEA estimates. However, sub $40bbl crude will result in further year over year reductions to producer's capital spending as cash flow declines, revalued borrowing bases shrink and capital markets remain closed to most energy names. As a result the EIA projects further declines in rig counts and forecasts 2016 North American production to decline by 800K b/d from 2015 average daily production levels to 8.5MM b/d by September 2016. The EIA is forecasting demand to grow by roughly 1.4MM bb/d in 2015 and 2016. Moreover, with oil futures trading sub $60bbl out to 2024, companies are unable to hedge. If US production shows a steady decline in production into the year, look for investors to take a more optimistic view on crude. However, risks associated with unknowns surrounding the impact of Iran's return and its level of oil in storage, and, to a lesser degree, Russia production and slowing Chinese/emerging market demand should keep prices capped at sub $50bbl through 2016.
While near term there is a large amount of uncertainty surrounding oil names, the 15% to 20% decline in capital spending in 2015, followed by further cuts in 2016, will set the stage for a rebound in crude prices. Sustained under-investment levels and low oil prices are accelerating declines in mature fields production. Within 2 to 5 years - even in a scenario with low or no demand growth - as conventional reserves deplete, shale production will need to take a more prominent role in meeting global oil demand if only to offset depletion. As the sharp decline in the US rig count at an average oil price of ~$46 bbl this year illustrates, oil prices will need to be higher to incentivize shale development given its higher cost of production relative to conventional production. As such, beginning in 2017, it appears that we may see a structural shift in the oil market as the need for more, higher cost shale production drives a sustained increase in oil price.
Despite considerable near term overhangs clouding oil market outlook, there continues to be investable sub-sectors within the energy markets that warrant attention: US independent refiners, petrochemicals and shale focused oil producers. Currently, US independent refiners are ideally positioned to profit from the lower for longer outlook in crude prices. As a result of the shale revolution, they have abundant and stable access to crude. There is some concern the lift of the export ban on US crude will negatively impact refinery earnings, however, this concern seems overblown and any sell off that result from the removal of the ban is a buying opportunity. Current WTI (West Texas Intermediate, the US benchmark oil grade) prices do not support export economics which need a $4 difference between WTI and Brent (world benchmark crude) to work. The scale of infrastructure needed to support exports is non-existent and has long lead times to develop. Importantly, refined product prices do not reflect discounted WTI prices but marginal high cost barrels, the world oil price. It also is worth noting, petrochemicals names are facing a similar dynamic in the era of cheap natural gas and natural gas liquids (NGLs). The use of ethane and propane feedstock at North American and Middle Eastern petrochemical companies affords them a significant cost advantage relative to naphtha, an oil based feedstock used by European and Asian producers. With significantly more shale production needed to meet global demand and offset declines in mature conventional fields, longer term - some shale focused names will become attractive. Companies with capital discipline, solid balance sheets, and acreage in high return formations such as the Eagle Ford, Niobrara, Permian or Bakken will be ideally positioned for sustained growth. For investors with long-term horizons and the ability to handle market-to-market losses, post forthcoming downward earnings and production guidance, names that meet the aforementioned criteria should be of interest.