This is the final installment of a seven-part series on investing in the energy sector. Throughout the series, the data seemed to suggest that the price of oil was poised to move lower. From its high in mid-2014, oil prices have plummeted approximately 67%. After such an enormous decline, we are left with two essential questions: Where will oil prices go from here? Is it finally time to invest in the energy sector?
Reviewing the Data
In the series so far, we have analyzed a considerable amount of data pertaining to the energy sector. We learned that when the oil VIX rises – reflecting an expected increase in oil-price volatility – oil prices tend to decline. We also discovered that when contango is high (i.e., the future oil price is higher than the current price), oil ETFs do not track the price of oil very well and in fact, tend to underperform.
We addressed one of the more interesting aspects in the September article (Is Now a Good Time to Invest in Energy? A Look at the Fundamentals) which included a production/consumption graph from early 2010 through September, with a projection through the end of 2016, courtesy of the U.S. Energy Information Administration. The daily closing price of oil (i.e., WTI) was also included in the graph.
This is what we found. The price of oil closely followed the supply/demand ratio between 2010 and September 2015. The EIA projects production will exceed consumption through the end of 2016. If this is accurate, it is a strong argument for lower oil prices. Was the EIA’s assumption correct? In mid-September, WTI was about $45 per barrel. Today, it is around $36. Thus far, the notion of cheaper oil has been spot on. Let’s look at the factors that influence the price of oil.
Because the price of oil is highly dependent on global supply and demand, the condition of the world’s economy is especially significant. When the global economy is strong, demand for oil and oil-related products increases, and oil prices tend to rise. Conversely, when economic conditions are weak, oil tends to decline. This raises the question: How strong is the global economy? In 2015, worldwide GDP has been around 2.5%. What is the outlook for 2016? According to the Conference Board, an independent research association with a global footprint, worldwide GDP in 2016 will be around 2.8%. Moreover, it expects GDP will be range-bound for the next 12-24 months. In other words, the Conference Board expects the global economy to be weak, which argues for low oil prices. However, demand is only one part of the equation.
Oil prices sometimes rise during periods of global economic weakness if demand is strong relative to supply. Even though supply has fallen over the past 12 plus months (+/-), the reduction has not been enough to stabilize the price of oil. As we discussed earlier, the U.S. EIA projects supply will exceed demand through the end of 2016 and possibly longer. The rationale for the supply side of the equation may stem from a basic tenet of human nature: the need for money.
Governments need money to operate, companies need money to generate a profit, and individuals need money to subsist. To develop this further, we must examine the oil-producing nations and focus on those who have been particularly hurt from the collapse in oil prices. Here are the four worst global economies and their current GDP (Y/Y):
Venezuela and Iraq are members of OPEC. All derive a significant portion of their revenue from oil. Because these countries have a strong need to replace the revenue lost to lower oil prices, a production cut is very unlikely. Of course, supply and demand are not the only factors for the price of oil.
Reserves and Disruptions
Other factors that influence the price of oil include the amount of current reserves, natural disasters, and anything that would disrupt the extraction or transportation of crude. One of the largest organizations, OPEC, produces over 40% of the world’s oil and its member nations control nearly 75% of the world’s total reserves. These countries are also located in areas where conflict and political turmoil is commonplace.
If we experience any type of disruption and the amount of reserves is low, if the conflict is serious, we would likely see a spike in oil prices. Fortunately, total provem oil reserves are high, which is a positive in the event of such an event. However, a large amount of reserves is a negative for production.
Where Do We Go From Here?
After factoring in the supply/demand data and other factors, which way is oil headed? The following chart contains the most recent forecast from the U.S. EIA. Historical data is to the left of the grey dotted vertical line and the forecast is to the right.
Here is a summary of the data:
1) The oil market is in contango as oil futures are slightly higher than the current price (green line).
2) The short-term energy outlook is slightly more bullish with prices peaking around $54 in mid-2016 before settling at $52 by the end of the year (red line).
3) Upper Boundary: There is a 95% confidence that oil prices will not exceed $56.60 (February-2016) and $90.24 by year-end.
4) Lower Boundary: There is a 95% confidence that oil prices will not fall below $32.07 (February-2016) and $25.89 by year-end.
Are oil prices headed higher or lower? Is it finally time to invest in the energy sector?
On the first question, based on anticipated weak economic conditions, tepid demand and excess supply, the price of crude will likely remain low. The second question is a bit more challenging.
In the wake of the oil price collapse, several companies have already filed for bankruptcy protection. Many others are delaying their loan interest payments and will likely follow suit. The negative ramifications of drastically lower oil prices could send mild to moderate shock waves throughout the global financial system. Moreover, if oil prices remain depressed for an extended period, the answer to the second question will depend on how well oil and gas companies adjust.
In essence, can those companies make a profit with prices this low? The energy market has already suffered quite a bit and it may be a little early to dive in. However, you might want to get the swimsuit ready because the right time may just around the corner.