While oil markets haven’t been experiencing much love of late, there’s a strong case to be made based on the fundamentals for the energy sector.
Recently, on Financial Sense Newshour, we spoke with Marshall Adkins, Director of Energy Research at Raymond James, on why he sees a "meaningful upside" for oil prices and how "fake news" is dominating the energy markets currently.
For audio, see The Topping Process; Perfect Storm Coming to Energy
Reductions in Capex Spending May Drive Depletion
We’ve definitely seen capital expenditures (capex) slow, and when we see cuts to international and offshore spending by 50 percent, it’s obviously going to have an impact on the price of oil.
It’s also important to keep in mind that in the case of offshore and international projects, the lead time is very long.
“The spending we’re not doing today actually won’t show in the numbers until 2019 or 2020,” Adkins said. “When it does, we think not only are US producers going to have to satisfy growing global demand but declines from outside the US and declines from offshore.”
It’s hard to gauge what those numbers will look like, but will probably amount to a half-million barrel a day decline in production between 2020 and 2022, Adkins stated.
If demand is growing by 1 million barrels a day, and production is falling by half-a-million barrels a day, US producers are going to have to come up with an additional 1.5 million barrels a day every year for at least 5 to 10 years.
“If you’re not spending the money, depletion is going to hit you,” Adkins said. “Our math shows that by 2020 to 2021, it’s going to be very difficult for the US to grow production 1.5 million a day unless you see meaningfully higher oil prices and more activity than we have today.”
Fake News Drives the Oil Price
Ultimately, sentiment and the way investors digest news about oil markets is helping to push down oil prices right now, Adkins noted. Over the last 9 months as we’ve seen the downturn in oil play out, the downturn itself has created a negative feedback loop, he added.
Industry pundits are essentially forced to try to explain the downturn, creating a misleading narrative for why it happened, further weakening prices.
“That’s created a lot of this ‘fake news,’ or negative hyperbole,” Adkins said. “One of the key things that fit into that negative hyperbole is numbers from various agencies that are just inaccurate.”
These oil market metrics are intrinsically hard to measure, he noted. For example, if we look at International Energy Agency data, which most models are based on, historically the IEA has revised its demand numbers up over the last 10 years by about a half-million barrels a day every year after the initial reporting.
Thus, for models beginning with demand numbers that are markedly understated, the market will appear to be oversupplied, even though inventory data, which tends to be more accurate, is telling us we’re in an undersupplied market.
This is also evident in gasoline demand reporting this year, as the US Energy Information Administration has suggested that year-to-date, gasoline demand is negative. However, miles driven year-to-date are up 1.6 percent, Adkins noted.
The EIA is reporting negative gasoline demand, when it appears to be very robust in the US, along with distillate demand in the US and elsewhere in the world, he stated. Additionally, inventories have fallen at the fastest pace we’ve seen in the past 7 months.
“If inventories are falling, it’s a very clear sign that the market is undersupplied,” Adkins said. “So far, the market, from a pricing perspective, seems to be ignoring what I think are very strong fundamentals.”
Productivity Gains Have Changed the Shale Market
As we’ve ramped up shale well production, we’ve seen average productivity per well grow about 35 percent per year.
“I challenge you to find another industry in the US that’s seen its productivity grow 35 percent a year for 5 years, particularly when it’s 150 years old,” Adkins said. “The feat that the US energy industry has accomplished is absolutely staggering.”
The problem is, these efficiency gains feed the law of diminishing returns. This rapid rate of productivity increases is unlikely to continue, as shale wells show significant production declines after year 2.
This will be the biggest challenge for the industry going forward, Adkins stated. If we see productivity gains go to zero or turn negative by the end of this year, that’s a very bullish indicator for crude prices.
Oil Will Average to by Year End or Next Year
With the massive inventory drawdowns that we’ve already seen this year, Adkins is surprised we haven’t seen the oil market already respond positively.
“At the end of the day, the fundamentals always win,” he said. “I think the catalyst is going to be a combination of things. But it starts with the physical market and the players that are actually buying and selling the crude.”
He expects these physical market participants to meaningfully begin to refill inventories towards the end of the year and into the first quarter of 2018, driving prices higher.
“We think prices average next year, which is obviously meaningfully higher than the -ish range we’re looking at today,” Adkins said. “Based on every trend I see, I think there’s meaningful upside in the next 3 months, and I think that carries through the full year of 2018.”