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Tightening Oil Market

A summer correction in oil prices has left many guessing whether this year’s rally mirrors last year’s short-lived recovery. Roberto Cominotto sticks to his forecast for a tightening oil market.

Thursday, August 11, 2016

Oil production has declined significantly in the first seven months of 2016, especially in the US shale oil market, which is typically the first to react to price changes because of its very short investment cycles. And unlike in 2015 when expectations of oil supply declines proved to be premature, the list of countries with falling oil production has been increasing this year to include such important producers like Venezuela, Mexico, Colombia, China and Nigeria. At the same time, demand for oil continues to grow in all regions, particularly in emerging markets.

Unplanned supply disruptions in Canada and Nigeria have even created a small supply deficit in the second quarter, much sooner than we expected. This might have created too much short-term optimism and the return of some of this supply in combination with an upcoming seasonal demand weakness resulted in a correction to oil prices. The supply/demand picture may remain weak in the very near term due to seasonal effects; however, the correction should only be of short-term nature.

Production to decline further next year

While we expect a slow recovery of US shale oil production, global conventional oil production is likely to decline in 2017. Major oil companies, independent producers and national companies remain under pressure to cut investments. Activity outside of North America is unlikely to recover before 2018. Once producers will start investing again it will take at least two to three years before production volumes will show an impact. This is important because people tend to mainly pay attention to what the US and OPEC are doing in terms of production, when in fact 50% of crude oil comes from outside of these markets.

What does this mean for our oil price projection? We expect oil prices to move toward the USD 50-55 per barrel area by the end of this year and to around USD 60 per barrel in 2017. The latest correction in oil prices only increases our conviction that the oil market is entering a multi-year period of tight supply. Each week that passes with oil prices below USD 60 further damages the oil supply capacity, deepening and prolonging the oil supply deficit in the coming years and increasing the risk of future price spikes.

Natural gas price rally may be ahead

Not just oil prices have recovered this year. Natural gas prices in the US have soared as well. We expect them to remain on an upward trajectory for the coming 12 months. Similarly to the US oil market, natural gas producers have slashed investments. The number of active natural gas rigs has fallen considerably, and currently only 81 rigs are in operation in the country. In the US – the largest natural gas producer in the world – that means many producers are operating without drilling rigs and that production will inevitably decline. This comes at a time when demand is growing because coal plants are being replaced by natural gas plants and gas exports are ramping up. If the 2016/2017 winter is colder than usual, this could result in a dramatic spike in gas prices. However, unlike in oil, we expect the natural gas price spike to be short-lived as there are still enough resources to increase production at relatively low prices.

Opportunities for investors

We expect higher commodity prices to support the entire energy complex. In terms of investment opportunities in the sector, US natural gas producer Gulfport Energy looks interesting. It is able to grow production by 20–30% in 2016 and 2017 despite record-low gas prices. It is one of the lowest-cost natural gas producers with a solid balance sheet. It has a large inventory of undrilled locations should gas prices recover. Looking beyond producers, US Silica is a US fracking sand supplier and will be a key beneficiary of a recovery in US shale oil and gas activity in the second half of 2016 and the following years. Sand used for fracking is the strongest secular growth market in the shale oil and gas industry. Sand volume per well is increasing by about 20–25% per annum. Revenues look set to double from 2016 to 2018.

We also see plenty of potential outside of the conventional fossil fuel sector, as renewables are increasingly becoming cost competitive with conventional energy. Global policy support for renewables and an increasing focus on energy efficiency make this sector a good investment, in our view. One area we like is US wind power, where we own Pattern Energy. The company has a strong growth pipeline thanks to the extension of US renewable tax credits. Its revenues are expected to almost double from 2015 to 2018 and the dividend yield is above 6%.

Nothing in this material constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions in this material are those of the author at the time of publication and may not reflect his/her views thereafter. The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the author.