If you’ve got your eye on the energy sector in 2015, you know one thing about oil prices: They’re really low. The cause? A global oil supply glut, helped by the emergence of the U.S. shale industry, a drill-happy Saudi Arabia and, most recently, the prospects of Iranian sanctions being lifted.
Crude oil prices have taken a 50% hit in the past year, and the abundant supply of oil has caused many otherwise sensible market experts — including InvestorPlace’s own Jeff Reeves — to turn bearish on the fossil fuel.
I can get on board with the fact that the case for oil’s resurgence is far from a sure thing, and that stubbornly high production combined with flat demand doesn’t support the idea that oil prices will rebound anytime soon. Plus, as a consumer, I’d like to see oil prices stay in the gutter well into my old age.
But as an investor, it’s not about my selfish preferences, and I change my outlook as new information presents itself.
Here’s why I think the days of $50 barrels of oil are coming to an end:
Iran Factored in Too Heavily
It’s important to remember that commodity prices aren’t determined merely by suppliers and end-users. They’re also determined by traders and investors — hey, if you’re reading this, you probably think about commodities as investing tools.
Oil is no exception.
Right now, traders are putting too much stock in the lifting of Iran sanctions. In reality, the impact on global oil supplies will be minimal. From the U.S. Energy Information Administration:
“Iran produced 3.6 million b/d of crude oil in late 2011, before the recent round of sanctions was enacted. The sanctions forced Iran to shut in a substantial portion of its production, lowering output to an estimated 2.9 million b/d in June 2015.”
Assuming Iran immediately ramps up production to its previous levels, that’s an additional 700,000 barrels/day in global oil production. However, the EIA expects global oil production this year to average 95.46 million barrels/day, meaning Iran will contribute to a 0.7% increase in supply.
That’s not a big dent, and considering oil prices are off 18% in the last month as the deal materialized, it’s fair to say that speculators are overestimating Iran’s pricing power.
Saudi Arabia Cutting Production in Fall
More importantly, the world’s largest oil producer, Saudi Arabia, is doing an about-face and finally planning to ease its production in the fall, according to the Wall Street Journal. Saudi Arabia pumped 10.56 million b/d in June, a record high, but the autumn cuts could amount to a production reduction of between 200,000 and 300,000 barrels per day.
Sure, it’s not even enough to offset Iran’s hypothetical 700,000 b/d increase, but it’s more important for its policy implications than its immediate impact on market economics.
The Saudis have been drilling like crazy this year, abandoning efforts to support oil prices and opting instead to maintain market share and put the U.S. shale industry on the ropes. By reducing production, the Saudis are telegraphing their belief that they’re back in control.
American producers, after all, are feeling the pain. The U.S. onshore rig count has been plunging, and on top of that, oilfield services companies like Halliburton (HAL) and Schlumberger (SLB) have cut thousands of jobs, while producers Royal Dutch Shell (RDS.A, RDS.B) and Chevron (CVX) have also slashed their workforces. It makes sense Saudi Arabia is planning to flex its muscles again soon.
U.S. oil production is supposed to fall by about 200,000 b/d next year, but don’t be surprised if the supply decline is steeper than that.
History Repeats Itself
My ears perk up any time someone declares there’s a “new normal,” dismissing the lessons of history as too antiquated to hold water in a modern economy.
Trying desperately to contain my excitement, I inquire innocently as to what this “new normal” is. And that’s how you find the other side of a good trade.
If we look to recent history for times when oil prices have plunged 50% or more, we see it doesn’t happen that often. The last two times it has happened, investors who went long on oil after those selloffs have been amply rewarded:
- In December 1996, oil sat at an inflation-adjusted $38/barrel, but by December 1998 it was at $16. Five years later, oil was at $41/barrel, up more than 150%.
- Between June 2008 and February 2009, oil plummeted from $146/barrel to $44/barrel. Roughly two years later, in April 2011, oil had rebounded more than 160% to $116 per barrel.
Within the next five years, oil prices will soar. I expect that on the conservative end they’ll jump 70% over that time, though I wouldn’t be surprised to see them double back to around the $100/barrel mark.
The safest way to wager on that five-year upside is probably an investment in one of the integrated oil majors like CVX or Exxon (XOM), both of which are sporting depressed valuations.
Let the guy who thinks $50 oil is the “new normal” take the other end of that one.
As of this writing, John Divine did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @divinebizkid or email him at editor@investorplace.com.
