Oil traders are back in panic mode, pushing West Texas Intermediate (WTI) crude down 15% from its high in June, taking oil stocks down with it.
But here’s the good news: This is creating the third great buying opportunity in oil stocks this year, and it’s time to step up and take advantage. I’ll suggest some good stocks to consider, including some offering yields of 6% to 10%.
First, here’s what’s spooking traders. There’s been a minuscule uptick in the rig count in the U.S., and a small upward revision in production estimates. Overseas fears include angst about a global meltdown because of Greece and China, and the prospects of Iranian oil coming back online.
“I think we are near the bottom, and oil should go up for the rest of the year,” said Mike Breard, an energy analyst at Hodges Capital Management. “It wouldn’t surprise me to see oil at $75 a barrel by the end of the year.” He’s referring to WTI, which recently traded at $52.50 a barrel.
Credit Suisse energy analyst Jan Stuart thinks oil will end the year on a “high note,” with WTI at $67 a barrel and Brent at $71. Brent recently traded at $59. Will Riley, who helps manage the Guinness Atkinson Global Energy Fund GAGEX, +0.08% sees an average of $70 for WTI and $75 for Brent next year.
Here are the five key things you need to know about oil to understand why crude is going up.
No. 1: U.S. energy companies are getting beaten into submission, and their production will decline.
Anyone who thinks a little uptick in the rig count and the Department of Energy’s (DOE) April production estimates signals that U.S. producers are roaring back should consider the following two data points.
Last year, 80 U.S. energy companies tracked by Credit Suisse invested $124 billion in capital spending. This year, their cash flow will dwindle to $58 billion, according to analysts’ estimates.
That’s a huge gap. That big drop in cash flow means much less capital spending and much less drilling.
As for the recent tiny increase in the rig count (by 14), it’s really meaningless when you consider how much it’s fallen since last year, says Breard. The U.S. rig count was down 56% to 831 at the end of the second quarter from 1,872 in October, points out Goldman Sachs analyst Brian Kinsella. He expects the rig count to average 850 in the third quarter. And capital spending? He thinks that’ll decline a massive 42% at U.S. producers this year to $90.2 billion from $156.1 billion last year.
All of this matters a lot, because U.S. producers were behind the supply growth that made Saudi Arabia jettison its role as the swing producer supporting oil prices. That policy change is one of the main reasons oil prices have tumbled in the past year.
Now U.S. companies are the swing producers. And their production is swinging — down.
By how much? We’ll get the next DOE update on U.S. production (for May) at the end of July. Mark your calendars.
Meanwhile, here’s some insight on what we might see. Stuart, at Credit Suisse, crunches numbers in more up-to-date data flow that comes from DOE “shale productivity reports.” These track rig activity in seven big shale basins. Stuart’s work suggests U.S. oil production rolled over in the second quarter.
This is one reason Stuart thinks U.S. crude oil production will end the year below 9 million barrels a day, down from 9.69 million in April. If so, all else being equal, that could tip the global supply-demand balance into deficit, compared to a current surplus that may be as little as a half million barrels a day. (Estimates vary.) That’ll support higher oil prices.
No. 2: The main OPEC players are pretty much maxed out.
The Organization of the Petroleum Exporting Countries (OPEC) supply has risen sharply since November. That’s mainly because of higher output from Saudi Arabia and Iraq. They’re now up to about 10.3 million and 4 million barrels a day, respectively. But those might be their limits.
Saudi Arabia is producing at its highest level in 40 years. “That’s not to say they can’t produce more,” says Riley, whose Guinness Atkinson Global Energy Fund outperforms competitors over the past 10 years, according to Morningstar. But by driving oil prices down so much, Saudi Arabia has now pushed its national budget into deficit. Sure, it has $750 billion in cash, so it can hold out for years. But it could be at its production peak for a while given it is at historical highs.
Iraq may need infrastructure upgrades to produce more, says Riley. OPEC members Nigeria and Venezuela need oil above $100 for their national budgets to balance. They’ve got no incentive to push oil prices lower.
The big OPEC wild card is Iran, with the world’s fourth-largest oil reserves. Iran will increase production now that trade sanctions will be lifted due to an international agreement on its nuclear program. No one knows for sure, but that could bring half a million barrels a day in production online within nine months, predicts Riley. This is uncertain, and it could get delayed. Meanwhile, if it does arrive, a lot of it might get sopped up amid increases in energy demand. (More on that trend below.)
“The impact to oil markets is manageable,” says Credit Suisse analyst Thomas Adolff. Iran is “unlikely to engage in a bitter price war it cannot win.” Libya is another OPEC wild card to watch. But political instability there probably caps oil production for a while.
No. 3: Non-OPEC producers are comatose, excluding the U.S.
For most of the 1990s, oil traded at $20 or below. Then for most of the past five years, it was above $100. Believe it or not, despite the big increase, non-OPEC oil production, outside of the U.S., more or less stayed flat.
Now with worldwide oil industry revenue down by well over $1 trillion, annually, because of lower oil prices, non-OPEC producers outside the U.S. definitely won’t be adding more capacity. They’ll be cutting back. Brazil recently announced substantial cuts to its energy-development budget, and it trimmed its five-year production outlook, points out Breard at Hodges Capital Management. Expect more of the same around the world.
No. 4: The world has a long-term energy problem and, nope, the U.S. is not going to solve it.
Producers cranked out 93.5 million barrels of oil a day last year. More than half of that capacity is in decline. From 2005-2014, daily production rates declined by about 4 million to 5 million barrels a year (getting replaced by new capacity to keep up). Those were the years the industry was flush with cash.
Now that industry cash flow is getting whacked, decline rates are going up. How much? No one knows for sure, but here’s a guide. During the financial crisis in 2009, industry capital spending fell 10%. And the decline rate in daily production spiked to 7 million barrels a day on an annual basis, points out Stuart at Credit Suisse.
Now capital spending cuts are even bigger than the 2009 reductions. So decline rates might spike even more. The U.S. produces only about 10% of the world’s oil so, no, it’s not going to solve the problem. Here’s a big-picture data point that drives this problem home: Stuart estimates that about 30% of global production will need to be replaced by 2020.
No. 5: Energy demand is rising sharply.
Thanks to lower prices, oil demand grew by 2% in first and second quarters, and it will grow by around 1.75% in the third and fourth quarters, predicts Stuart.
No, Greece is not going to derail European growth and energy demand. And the recent meltdown in China’s stock market won’t hit energy demand there either. The stock market losses aren’t big enough to hurt consumer spending. Indeed, the growing middle class in China and other emerging economies — one of the big global mega trends — will bring stronger demand for cars and other transportation, which means more oil demand. One thing to watch: Some recent data from China suggest growth is slowing.
Three energy stocks favored by Riley at the Guinness Atkinson Global Energy Fund are BP BP, +0.93% which pays a dividend yield over 6%; Newfield Exploration NFX, +2.32% ; and Carrizo Oil & Gas CRZO, +2.84%
Attractive yield plays
You might also consider master limited partnerships (MLPs), which operate in energy infrastructure, especially if you are shopping for yield. They look exceptionally cheap right now, says MLP expert Jay Hatfield, chief investment officer at Infrastructure Capital Advisors.
As a group, MLPs offer distributions that equate to a 7.25% yield, which is about 5 percentage points over the yield on Treasuries.
“It is rare for them to trade this wide,” says Hatfield, who has managed MLP investments at Stephen Cohen’s SAC Capital. Typically, MLPs outperform for one to two years after they trade at such a discount. “The sector is very attractive.”
On he favors is Plains All American Pipeline PAA, +0.60% which has a yield of about 6.6%. MLPs can bring headaches at tax time, so consider an MLP exchange traded fund that Hatfield’s firm manages, InfraCap MLP ETF AMZA, +1.17% Not only does it eliminate the complicated MLP tax paperwork, it pays a 10.7% yield.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested BP, SWN and HP in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.