West Texas Intermediate (WTI) crude oil has ranged between $43 and $53 per barrel in 2015, down sharply from its high of more than $107 per barrel last July. The commodity currently trades toward the top end of its recent trading range.
Some analysts have called for a V-shaped recovery in crude-oil prices that would propel WTI to about $70 per barrel by early 2016.
Although crude oil will experience short-term rallies, investors should remain skeptical of any strength in WTI prices. Our forecast calls for oil to slip to about $30 per barrel at some point in the first half of 2015, followed by a prolonged period where the commodity fetches less than $60 per barrel.
Projections for a major rally in crude-oil prices appear premature, as the supply and demand factors that drove the collapse have yet to run their course.
The severe downdraft in the prices of crude oil, natural gas and natural gas liquids has created buying opportunities in the energy patch, but pundits calling for investors to buy the dip in energy producers and oil-field services names are too early.
Three major factors make us skeptical about the sustainability of near-term rallies in crude-oil prices and the most commodity-sensitive energy stocks.
US refiners usually shut down a proportion of their capacity for maintenance and upgrades in the fall and winter months, tempering demand for crude oil. However, these turnarounds wind down in the spring, when operators gear up for the summer driving season.
Check out this graph comparing US refineries’ average daily consumption of crude oil over the past five years to the run rate thus far in 2015.
US downstream operators idled an average of 1.5 million barrels per day of refining capacity during the first two months of the past five years; the refinery complex then runs at reduced capacity for the first 11 weeks to 12 weeks of the year.
Starting in the second quarter, refining throughput gradually increases through week 28 (roughly midyear). Based on the five-year averages, the pick-up in demand from the first quarter’s seasonal lows to the midyear highs hovers around 2 million barrels per day.
Bullish commentators often argue that US inventory builds should begin to moderate this month, as refineries ramp up their activity. However, this argument ignores the facts on the ground: Refinery margins have widened markedly since January, prompting operators to run their plants at elevated utilization rates in the first quarter.
With US refineries already running at 89 percent of their nameplate capacity, the industry has limited scope to boost throughput rates over the next few months. In other words, the uptick in oil consumption will fall short of the 2 million barrels per day averaged over the previous five years.
Investors betting on this seasonal bump to help alleviate elevated inventories likely will be disappointed; the volume of oil in storage has continued to grow at a faster-than-expected pace despite refineries running at higher utilization rates.
We reiterated our bullish stance on refiners in October 2014, predicting that these names would benefit from widening profit margins. (See Buying the Selloff: Upbeat on Downstream Operators.)
Our view proved prescient, with the Energy & Income Advisor US Independent Refiners Index rallying 26 percent from Mid-October 2014 to the end of February 2015. However, we recently sold Valero Energy Corp (NYSE: VLO) and Alon USA Partners LP (NYSE: ALDW) from our model Portfolios for sizable gains, based on our belief that US refinery margins had peaked and that the risk-reward balance had shifted. (See our March 23 Alert, Taking Profits.)
Refiners benefited during the winter months from strong demand for heating oil and the widening price differential between WTI and Brent crude oil, an international price benchmark; both tailwinds have diminished since the end of February, a development that catalyzed our decision to book profits.
Each Wednesday, the Energy Information Administration (EIA) releases data on US oil production, oil inventories and refinery runs.
On April 1, 2015, the EIA estimated that US oil production fell by 36,000 barrels per day—the first weekly decline since the end of January. The market seized on this data point, with some commentators asserting that this news marked the start of the long-awaited drop-off in US oil output.
Unfortunately, one- and two-week declines in weekly oil production have occurred regularly without affecting the overall uptrend—and that’s before the US oil-directed rig count began to plummet last fall.
For example, the EIA’s weekly estimate of US oil output dropped by more than 100,000 barrels per day in the final week of July 2014 and 36,000 over the seven days ended Jan. 30, 2015.
Investors’ eagerness to twist last week’s statistically insignificant blip in oil production—an inherently noisy data set—underscores the kind of wishful thinking that helps to catalyze short-term rallies in a bear market. This news also gave traders an excuse to take profits on their short positions.
Although bullish pundits often cite the precipitous decline in the US rig count to support their case, recent trends in this data set should be of greater concern than a weekly decline in the EIA’s oil production data.
Since the start of December, US producers have idled about 800 oil-directed rigs since the start of December 2014, almost halving the number of active units in four months—one of the sharpest declines since Baker Hughes (NYSE: BHI) began publishing this data in 1987.
Reduced drilling activity eventually will slow the pace of US oil production growth, drawing a line under the price of this commodity and setting the stage for a bit of a bounce.
But commentary from most of the major shale oil and gas producers suggests that these companies have laid down rigs targeting noncore acreage, focusing their development efforts on their best plays. Even if WTI hovers around $50 per barrel, the best producers can still turn a profit in these prolific areas.
With the magnitude of the weekly decline in the US oil-directed rig count shrinking, producers appear to have focused their efforts on their best acreage, implying that oil prices would need to drop further to encourage operators to reconsider their development plans.
And if oil prices climb to between $55 and $60 per barrel in the near term, the US rig count could tick up, further prolonging this adjustment process.
Last fall, we forecast that WTI would slip to about $40 per barrel by early 2015; later in the year, further deterioration in the supply-demand balance prompted us to lower our price target to about $30 per barrel.
Although pundits love to speculate where and when crude-oil prices will bottom, how long the commodity trades at depressed prices will hold more sway over profits in the energy sector and stock performance.
We expect oil prices to bottom this year but remain lower, less than $60 per barrel, for longer than many investors and analysts expect. The growing shadow capacity—production that can be brought onstream relatively quickly in response to an improvement in oil prices—will prevent WTI from breaking out of its trading range.
The inventory of wells that have been drilled but not completed continues to grow, as producers with the wherewithal to do so hold off on putting these wells into production until oil prices improve. This looming shadow capacity will keep a lid in oil prices.
Check out this graph from EOG Resources’ (NYSE: EOG) March 17 investor presentation. Management has decided to delay the completion of oil wells in the Eagle Ford Shale, a prolific play in South Texas, until oil prices rally to about $65 per barrel. EOG Resources’ internal rates of return would improve significantly even if 24 months pass before oil prices recover to this level.
In the short term, these deferred completions will support crude-oil prices by reducing the number of new wells that come onstream to offset the natural decline rate of existing production and drive output growth.
However, if oil prices rally to more than $60 per barrel, you can expect producers to tap this shadow inventory in a rush to take advantage of favorable prices. This upsurge in supply would short-circuit any recovery. This phenomenon resembles what’s transpired in the US natural-gas market in recent years.
Elliott and Roger on Aug. 27, 2018
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