MRP’s call on crude oil has been contrarian since its inception. Even now, although the West Texas Intermediate (WTI) benchmark is pricing oil at over $66 per barrel, well above the lower half of our $60 – $80 prediction, oil should still climb higher yet. Not only that, but we also believe that energy equities, should finally pick up the pace.
Back in April of 2016, “lower for longer” pricing was the outlook of many on Wall Street who were suffering from a case of Status Quo Bias, or SQB. The massive oil glut that sent prices tumbling more than 70% from 2014 to 2016 was so intense, that it caused many to think that oil would never regain its footing with skyrocketing US output via shale fields. The logic behind this assumption is understandable, but for every action, there is a reaction. This assumption underestimated the ability of most of the world’s oil producing countries to cut their own production and drain inventories, simultaneously overestimating shale’s efficiency and US producers’ ability to generate a profit with lower crude prices.
Crude Oil Prices:
The new consensus view that MRP dissents from is that, since oil prices have now risen to a range allowing shale to once again be profitable, US producers will ramp up production and flood the market yet again.
However, production has never been the problem. American production has been steadily increasing and is already at an all-time high of over 10.5 million barrels per day. There is also the belief that oil companies could begin tapping into drilled but uncompleted wells (DUCs), but here, SQB might be discounting the costs associated with such an operation. Current completed wells are going to be the most productive, profitable wells in the US’s arsenal, each subsequent well that is completed will likely be marginally less efficient than already operational wells.
Last July, it would have cost $20.8 billion to complete the 6,031 DUC inventory, an average cost of nearly $3.5 million per completion. Although the DUC inventory has now increased to approximately 8000 wells, costs are also rising. Most major shale basins have actually seen a decrease in their total DUCs since 2014. The vast majority of DUC growth came from the Permian shale basin which alone composes about 40% of all DUCs. There was an estimated 10% increase in the cost index for the Permian region in 2017, completion costs for unconventional completions (fracked wells) are estimated to have increased 20%, along with drilling costs that climbed by 6.7%. U.S. shale oil producer Anadarko Petroleum Corp expects 10% to 15% increases in service costs this year for its operations in the Permian.
Further, as MRP noted last week, inventories in the US and OPEC are continually decreasing, well below the high levels experienced in 2016 at the height of the oil glut. For the first time since the bear market in crude oil began nearly four years ago, U.S. oil inventories are below their 5-year average level.
While crude commodity prices have risen strongly over the last 2 years, energy equities are still lagging. Once again, this comes back to SQB. Commodity prices are much more closely tied to supply and demand for a physical resource, whereas equities are subject to investor speculation about that resource. Investors simply did not expect OPEC to remain as disciplined as they have in cutting their output. However, even more than that, not many could have foreseen the optimistic economic momentum that swept over America following President Trump’s surprise electoral victory to and subsequent deregulatory agenda and tax cuts. A weak dollar has also been a boon to oil prices and growth across emerging markets.
Another element of SQB in the oil markets relates to backwardation. As it stands today, the futures market is convinced that oil is overvalued, and pricing in a lower value a year from now than the cash price today. While oil prices closed at $66.42 per barrel, April 2019 has crude at 61.31, as of close on Monday; a backwardation of more than $5. Since early 2017, the futures curve has been shifting from mild contango to steep backwardation. If the futures market remains this persistent in their prediction that oil is overvalued, companies will continue to take advantage of higher prices, breaking out of the slump they’ve sunken into as of late.
In the previous quarter, big oil players like Exxon Mobil reported more than doubling its earnings from the prior year. Valero also scored big in the final quarter of 2017, surpassing Wall Street analysts’ consensus estimate by about 21%. ConocoPhillips’ share price hit a 52-week high just last week, even in the midst of powerful market volatility that has inevitably played a role in energy shares’ slow response to an environment of climbing oil prices.
MRP recommended going long Oil and US Energy on April 8, 2016. The Oil ETF (OIL) has returned more than 32% outperforming the S&P 500’s 27% over that same time period. The Energy Sector ETF (XLE) has posted less impressive returns, gaining only 12% over the same period. In December 2016, we included Energy Services & Equipment to our list of themes on the basis that those companies would benefit from a pickup in exploration and drilling activities. That group, as represented by the Market Vectors Oil Services ETF (OIH) is down 23% since we added it on December 23, 2016.
Given the global geopolitical and technical factors outlined above, we remain bullish on oil and are reaffirming our $60-80 price target for crude.