Have Oil Prices Reached a Bottom?

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There’s no question that energy stocks have had a rough ride over the past year. After reaching a peak of over $100 in the middle of last year, the Energy SPDR (XLE) is currently scraping along around $65.

Have Oil Prices Reached a Bottom?The decline has easily made energy the worst-performing segment since the bull market began in March 2009, after outperforming considerably over the last decade.

The reason for the downward trend is simple: the plunge in oil prices from over $100 per barrel to under $50 currently.

The decline in oil prices began due to greatly increased U.S. oil production (up 80% from 2008 through 2014), as hydraulic fracturing, or fracking, was able to retrieve oil from previously hard-to-reach locations. High prices along with lower interest rates made such projects economical, resulting in a boom of U.S. oil supply.

Crude oil inventories in storage at Cushing, Oklahoma — the largest storage hub in the country — increased from 20 million barrels in the middle of last year to just under 60 million currently.

In addition, slower growth in demand from China played a significant role in declining oil prices — the thought that Chinese economic growth would continue indefinitely at close to double-digit rates had driven oil up sharply in the last decade.

Finally, there was quite a bit of feeling that high oil prices merely reflected trading and speculation, and that the situation was a house of cards that would fall apart at some point as fundamentals declined. In this case, the catalyst was the Organization of Petroleum Exporting Countries (OPEC) failing to reach an agreement in production cuts last November.

So What’s Next for Oil Prices?

While it’s difficult to predict the timing, a recovery in oil prices should begin as supply and demand come back into balance.

Oil demand tends to go up over time, with global numbers increasing from 75.9 million barrels per day in 2000 to 92.6 million barrels per day last year. According to the International Energy Association, further gains are expected — to 94.2 million this year and 95.6 million next year.

And although oil demand is widely regarded as cyclical, it’s worth noting that in the recession year of 2009, global demand fell to just 84.9 million from 86.2 million in 2008, then quickly recovered to 88.3 million in 2010.

On the supply side, U.S. drilling activity is slowing, with the Baker Hughes (BHI) rig count currently at 864, down from 1,925 a year ago.

There will be a lag effect to reduce supply, as the remaining wells still being drilled are very efficient. In addition, given the high fixed cost in oil drilling, once a well is operating at peak capacity, it is very profitable, even with lower oil prices. However, with the lack of new wells being drilled, supply will fall at some point, and given the steady rise in demand, equilibrium will eventually be reached. Supply would then tighten and prices should rise.

Bottom Line

I do believe we are close to a bottom for oil. However, it’s important to keep in mind that we have had a few false bottoms already, so the exact timing of a rally is hard to project.

I also believe that, given the difference fracking has made in increasing available supply to the United States, we will not see $100 per barrel for a long time — perhaps never again, as we begin a slow but likely definite transition to cleaner fuels.

But as we see a more definitive bottom emerge in this sector, keep an eye out for fresh buying opportunities in XLE and other once beaten-down stocks.

Hilary Kramer is the editor of GameChangersBreakout Stocks Under $10High Octane Trader, Absolute Capital Return and Value Authority. She is an accomplished investment specialist and market strategist with more than 25 years of experience in portfolio management, equity research, trading, and risk management. She has extensive expertise in global financial management, asset allocation, investment banking and private equity ventures, and is regularly sought after to provide her analysis on Bloomberg, CNBC, Fox Business Network and other media.

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