Grant's Almost Daily

PRICE OF OIL GOING UP

Let’s have another look at the oil market, where the sharp advance of early summer has been all but forgotten: Even with a strong bounce to finish today at more than $69 a barrel, West Texas Intermediate Crude is down 5% from its July 10 highs.  On an absolute basis, July was the worst month for black gold in an even two years. 

 

While a steep late June run-up (Almost Daily Grant’s, June 29) and demand concerns related to the U.S./China trade spat have helped set the stage for a pullback, oil bears have also found a friend in the Organization for Petroleum Exporting Countries. July production from OPEC came to 32.6 million barrels per day, the highest level of the year and not far from November 2016’s record output of 34.1 million barrels per day. Large output gains from Saudi Arabia and Russia, as well as a return to production from Libya after a multi-week outage fig ure in OPEC’s rising production. 

  

For the near term at least, the prospects for upside in oil are further clouded by an ominous development in the futures curve. Today, Bloomberg reports that the gap between the near contract and the following month contract for Brent crude has swung from a 53 cent premium in June to a 63 cent discount a month later, signaling a potential surplus in supply. Marwan Younes, chief investment officer at Massar Capital Management, commented: “The increase in supply from OPEC seems to be real and it’s already translating into an overhang in supplies of Brent.”

 

While OPEC ramps up, the U.S. shale machine continues to hum. According to the weekly estimates from the Energy Information Administration, domestic production remains at a near-record level of 10.9 million barrels per day as of the final week of July, nearly double the levels achieved in July 2011.  However, a second look at the data indicates that production might not be quite so flush. According to the latest EIA’s monthly Crude Oil and Natural Gas Production Report released on Tuesday, the revised U.S. output figures for May of 10.442 million barrels a day represents a reduction of 300,000 barrels from the prior estimate and remains below April’s 10.472 million daily output. Nevertheless, the newly slimmed-down May production figure represents a solid 13.3% uptick year-over-year. 

 

But while rising production and the trade war garner headlines, a potentially more impactful long-term development continues apace. According to Rystad Energy, discoveries reached a record low in 2017. While the consulting firm expects 2018 discoveries to rise 30% from last year’s trough, that uptick translates to only 20 billion barrels of discoveries in 2018, well below the 33 billion barrels in additional capacity needed to keep pace with demand. Espen Erlingsen, head of upstream research at Rystad, commented: 

 

An uptick of 30% from the abnormally low levels in 2017 might seem encouraging, but exploration and production [companies] are currently facing a low reserve replacement ratio, on average less than 10%.  This is worrisome considering the impact on global oil supply in the long term.

 

Overall, Rystad finds that global oil and gas companies will spend $440 billion on capital expenditures between 2015 and 2020, just under half the $875 billion in capex undertaken between 2010 and 2015.

 

In their second quarter letter, commodity investment firm Goehring & Rozencwajg Associates, LLC contend that the lack of investment will manifest itself in far higher prices over the long-term. Principals Lee Goehring and Adam Rozencwajg write:

 

Not only have huge cut-backs in global upstream  capital spending impacted conventional non-OPEC oil production, but our research tells us that cuts to upstream capital spending are now beginning to impact OPEC oil production as well.  Algeria, Nigeria and Angola have seen their production decline by over 1 million barrels a day in aggregate over the last four years. We believe those declines are directly related to inadequate capital spending. Combined with politically related production problems in Venezuela and Libya, OPEC spare capacity is rapidly falling to zero.

 

We believe the bull market in oil, (ignored thus far every step of the way by the investment community) is set to dramatically accelerate to the upside. 

 

Concurring with the viewpoint of our friends Goehring and Rozencwajg, Grant’s remains bullish on oil and a number of energy-related companies who would benefit from higher prices.