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Trading Lessons

Why Crude Oil Price Is Headed to $200 a Barrel

Commodities / Crude Oil Feb 03, 2015 - 04:19 PM GMT

By: Investment_U

Commodities

David Fessler writes: Editorial Note: As promised last week, here is David Fessler’s rebuttal to Sean Brodrick’s piece, “3 Reasons Why Crude Will Stay Under $50 Through 2015.” If you read the title of today’s article, you might think Dave and Sean have vastly differing opinions on the direction oil is heading. But to the contrary, both agree prices will move higher... the only question is, when? To help confirm his assertions, Dave reached out to an oil industry connection who served as president of one of the largest producers in the world.


Last Friday saw both Brent and WTI crudes jump 8%, with the March contracts closing at $52.99 and $48.24 per barrel, respectively. It was the largest one-day gain since June 2012.

Why the big move? Many traders are speculating that U.S. producers are pulling back on production a lot quicker than previous estimates.

They don't have to speculate any longer.

Baker Hughes Inc. (NYSE: BHI) has been keeping track of weekly drill rig data since 1987. In any given week, it can tell you how many rigs are drilling for oil and natural gas in the U.S. and just about everywhere else in the world.

It turns out that just in the past week, the number of U.S. rigs drilling for oil fell by 94. That’s a 7% drop, leaving 1,223 still prospecting.

That is the lowest number since October 2013. About three weeks ago, I started telling my Advanced Energy Strategist subscribers that I believed oil had bottomed.

My reasoning was that oil was oversold. I further stated that oil exploration and production (E&P) companies would overcompensate and cut costs further and faster than even the most bearish forecasts.

What an Oil Industry Insider Thinks

Looking back, that’s exactly what’s been quietly happening. Still, I wanted a second opinion. So I decided to speak to a top oil expert to confirm my suspicions.

I picked up the phone and called my friend John Hofmeister. John is the former president of Shell Oil Company. I’ve interviewed him before about energy prices for Investment U. Given his background, I can’t imagine anyone with a more informed perspective on the topic.

After he retired from Shell Oil Company in 2008, John founded - and today heads - the not-for-profit Citizens for Affordable Energy. This D.C.-based public policy education firm promotes sound U.S. energy security solutions for the nation.

Here are a few excerpts from my interview.

DF: Do you think this is a classic supply/demand situation, or are the Saudis protecting their own interests at the expense of the U.S. and Russia and other producers as well?

JH: Well, I think it's a combination, and I do think the expense is also on the Saudis because this is causing them to rely upon their savings, basically... this is costing everybody money, but it is actually a supply surplus that came about through the lack of demand growth that was expected in 2014. Here's what I mean: Companies make major capital decisions to invest in new production over a long period of time and they - state-owned oil companies as well as major oil companies and independent oil companies - looking in the 2012, '13, '14 time window, came to a conclusion that demand growth would grow by "X," roughly 3% per year. But it did not.

In other words, global economic growth was weaker than was projected two or three years ago... but the companies had already invested the capital to increase production, expecting consumer demand or, ultimately, global demand at about the 93 million to 94 million barrel level, when the demand is actually closer to 92 million. And so we have this extra built-in capacity, and we came to realize that about halfway through 2014, when China's growth... India's growth... just wasn't going to meet what was expected, and it looked like we had about a million barrels a day surplus by mid-year.

That was aggravated by a lot of financial companies liquidating their hard asset holdings of oil through the summer... they started liquidating hard oil assets, so we got more oil put into a market that was already in surplus, and we ended up with somewhere between 1 million and 1.5 million barrels a day of too much oil. And once the traders get a hold of that, then they're going to try to match buyer and seller with volatility... And so that drove the price down, the prices, way too low for normal equilibrium, and dropping 50%, 60% over about a 1% overage or 1% disequilibrium is really dramatic.

DF: When do you think prices will begin to reverse and head back up? And do you think it's the second half of this year (which is my thought as well)? I think it's going to take six months of volatility here and more overshoot and cost cutting, and then we're going to see a reversal... do you think they're going to head back up as fast as they went down?

JH: Or faster... The reason is we're so good at cutting costs. You know, we're going to have 500 rigs shut down by the end of this month from last October. There'll probably be another 200 to 300 rigs shut down in February and March, and nobody's going to bring those rigs back up until they have some security that the rise in the oil price will last for a period of time. Because they don't want to go through this again two years, three years from now, and so they will withhold spending money until they really have to get out there, or somebody else is going to take their place. And so what I see happening, and what most of the observers fail to ever mention, is the natural decline rate in 2015 will cost us 5 million barrels of production a day. Five million barrels a day by the end of the year.  [Emphasis added.]

That’s just a piece of my interview with John Hofmeister. To hear the entire thing (or read a transcript), click here.

The implications of what John told me could turn out to be conservative. If too many rigs are taken out of service too fast, the world could very quickly find itself with too little oil.

That could send prices soaring to $150 or even $200 per barrel. If you aren’t invested in the energy sector right now, you could miss this meteoric rise in the market.

Of course, you need to be invested in the right companies. One that I particularly like is Chevron Corporation (NYSE: CVX).

Chevron pays a healthy dividend of 4.17% annually. It trades at an absurdly low price-to-earnings ratio of 10.12.

And with a market cap of $194 billion, Chevron could easily snap up smaller E&P companies. Why do this now? Because Chevron would potentially get great acreage at cents on the dollar.

Chevron is just one example of a bargain energy stock rising from the ashes of the recent carnage in the energy sector.

Good investing,

David Fessler

Source: http://www.investmentu.com/article/detail/43224/why-oil-is-headed-to-200-a-barrel#.VNELiE1ya0k

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