The path to a recovery in oil prices

The U.S. Energy Information Administration (EIA) oil inventory reports show record-breaking storage levels each week. And this is during a time when refinery demand is typically slow, as distributors undertake scheduled maintenance activities. Total crude supply has increased sharply to almost 30 days of demand, the highest level since 1990. We believe U.S. crude inventories are likely to surpass 475 million barrels before the build cycle begins to reverse (see Chart 1, below).

But, we don’t believe oil inventories will hit capacity because as we go into the summer months, refinery runs will pick up as seasonal turnaround and maintenance is completed.

Still, some observers think there’s a possibility we’ll reach the limits of oil storage capacity, which is putting the futures market in steep contango. Yet, this further drives people to put crude oil into storage, instead of making spot market sales.

Read: Oil companies learning from price dip

Rig counts in the U.S. falling

Non-OPEC output grew at a record rate in 2014, extending the gains of recent years. North American supply growth represented 65% of global supply growth during the past five years thanks to shale oil plays.

But, the horizontal rigs in the U.S.’s big four oil basins, which have driven the U.S. shale oil boom, are collectively down 35% from their respective peaks. So, we’re confident there should be a significantly tighter oil market in 2016. Also, the U.S. has shed rigs during this price drop faster than during any other oil price collapse in recent memory.

35%

The horizontal rigs in the U.S.’s big four oil basins are collectively down from their peaks

Source: EIA, Cornerstone Analytics

U.S. oil production growth will likely fall in the coming months, but lag falling rig counts by about six months. Because of the relatively short cycle time in drilling, completing and tying in shale oil wells, unconventional oil production should be quickest to respond to lower prices.

Read: Benefit from energy without energy price exposure

Last month’s EIA Drilling Productivity Report suggested production growth from the major shale basins could actually reverse in March 2015, following the sharp pullback in drilling activity and with numerous producers opting to defer well completions (see Chart 2, below). Many U.S. producers are holding off on bringing wells with high decline rates on-stream due to a contango structure that sees future prices significantly higher than the spot market.

The market is focused on the activity slowdown in North America, but it’s only part of the supply picture (see Chart 3, below). The key is that the output in the rest of non-OPEC, which represents 70% of non-OPEC supply, has actually declined during the past five years—even with Brent oil prices above US$100 per barrel. Larger, more complex international projects require more lead time, and we could see a delayed response. It’s hard to envision how these regions can maintain flat production in the current US$60-per-barrel Brent crude environment when they couldn’t even stay flat at substantially higher prices.

Read: There’s more to oilsands development than the price of oil

Demand will accelerate

The market is disproportionally focused on the supply impact of depressed oil prices, namely on U.S. shale oil growth. Absent most discussions is the impact on the demand side of the equation.

People assume a dollar out of the pocket of a net oil exporter is effectively a dollar in the pocket of a net oil importer. But it doesn’t work that way. If the recent US$50 per barrel decline in fuel prices holds and is passed to consumers, then the stimulus from lower oil prices will approximate US$1.7 trillion, and cause global GDP to rise by approximately 0.5%. Closer to home, the impact of lower fuel prices on Canadian families is as much as $1,400 per month, or the tax equivalent of a 9% reduction.

Also, we expect demand to accelerate, thanks to lower fuel prices, so we think the perception that current global supply will continue to be higher than demand by approximately 1.3 million barrels/day could be wrong in the second half of 2015. In Chart 4 below, we see there will be seasonally stronger demand in Q3 2015 than Q1 2015. The seasonal impact alone could amount to an increase of 1.5 million barrels/day in Q3 2015, versus Q1 2015, and that’s on top of any demand increase from the stimulus of lower prices.

Read: Don’t avoid the energy sector

Positioning for opportunity

By the second half of 2015, energy equities should have better sight of tightening supply, demand fundamentals and high inventory levels in the absence of OPEC supply cuts. Without cuts as a catalyst for higher prices, or the wildcard of geopolitics, we see a U-shaped recovery as taking hold in the second half of the year.

Investors should continue to focus on energy stocks with strong underlying business fundamentals. The winners through this cycle will be conservatively capitalized companies with access to capital that can make countercyclical acquisitions, and emerge on the other side of this oil price rout as stronger companies.

by D. Mason Granger, P.Eng., MBA, CFA, is a portfolio manager in Toronto.