As we’ve learned over the course of the last year, making projections about oil prices can be a very difficult enterprise.
After rebounding to a little over $60 a barrel this summer, crude defied expectations and dropped back into the $40’s and even below to close out the year.
But don’t let this near-term move fool you. Certain elements are now gathering steam that will likely lead to a long-term rebound in crude next year.
In fact, there are several market forces that I believe will lead to higher oil prices in 2016.
And it all starts with a reduction in the “supply glut” that all the talking heads keep beating their chests about.
In this case, the reversal will occur in two phases.
First, as the year goes on I think we will see a dramatic shift in OPEC policy.
The primary element depressing oil prices has been OPEC’s strategy (led by Saudi Arabia) of maintaining and increasing production levels in order to defend market share, which started in Thanksgiving 2014.
In 2016, however, I expect this portion of the “supply glut” will begin to reverse.
Signs of Capitulation in the “Oil Price War”
In fact, several OPEC nations are now in open opposition to the Saudi policy, with Venezuela, Nigeria, Libya, Iran, and Ecuador leading the charge to make the production cuts that would ease the supply glut and send oil prices higher.
Economically, OPEC has painted itself into a corner, and the only way out now is through higher prices. Even the Saudis understand that.
That’s why Riyadh is now signaling to the likes of Russia and even the U.S. that they would support a joint move with non-OPEC producers to “stabilize” the international market.
Don’t be fooled by OPEC’s early-December decision to keep pumping. Low oil prices are hurting even Saudi Arabia, and something, or someone, will have to give.
And in a face saving caveat, I now believe the Saudis will finally end their call to “hold the line” on production, easing the oversupply and opening up the market to higher prices.
But that’s only half the story. The second phase of this capitulation will be happening here at home.
The reason why is simple. While the Saudis clearly underestimated the resolve of U.S. producers, the damage wrought by the “oil war” here at home has been extensive.
The U.S. rig count has declined precipitously, while forward capital expenditures – especially for deep, fracked, horizontal wells – have been slashed to the bone. What’s more, several major Arctic and Gulf of Mexico offshore projects have been mothballed as well.
That can’t help but lead to a drop in supply, especially when it comes to shale or tight oil. Fact is, the average unconventional oil well pumps the majority of its volume in the first 18 months.
It’s called the decline curve and it can’t be finessed forever.
Even with the application of secondary and enhanced oil recovery techniques, it’s only a matter of time now before we start to see a reduction in supply on the American side of the market.
Also, as I’ve pointed out for some time now, the “bad debt” problem on the energy side of the junk bond market is growing more acute by the day.
Bad Debt Will Diminish U.S. Oil Supply
Yield premiums are rising with no end in sight, and for drillers with a lot of debt to rollover that brings up the possibility of bankruptcy.
As a result, an increasing number of U.S. producers will disappear, be acquired, or merge with larger competitors, adding to the reduction in overall volume.
When the combination of these market forces take hold, the “supply glut” will undoubtedly begin to shrink.
As for the demand side, the global need for crude is expected to grow by an average of more than one million barrels a day annually, led by big increases in Asia.
Fact is, by OPEC’s own estimates oil demand in Asia will rise by about 16 million barrels a day to 46 million barrels by 2040.
To put that in perspective, that’s almost twice the amount currently produced by the U.S.
But as I’ve said numerous times before, this crunch has always been all about the supply side of the equation. Increasing demand has never been the issue.
And that brings us to where the price of oil is headed…
This is Where Oil Prices Go from Here
Finally, as I’ve noted over the past several months, a combination of derivative moves on futures contracts and heavy ongoing short plays have completely distorted the true value of oil.
And while “paper barrels” have always swayed oil prices for delivery (i.e. the “wet barrels”) that influence has grown far beyond any rational market justification.
In fact, I estimate the true market value for a barrel of West Texas Intermediate to be roughly $50 a barrel, or $8 higher than where it is as of the writing of this report.
What I can tell you is that these types of paper trades run in cycles. And as the profit potential from them begins to diminish, the “paper price” of crude will begin to rise to meet its true overall value as a hard asset.
Here’s what all this means.
Let me be clear: We are not racing back to $100 a barrel oil. Absent a major geopolitical outlier that impacts supply, more subdued increases in crude are in order.
Therefore, my current read on West Texas Intermediate is as follows:
- By July 1, 2016, WTI should price at $66/barrel.
- By October 1, 2016, WTI should price at $68/barrel.
- And by January 1, 2017, WTI should finally breach $70/barrel.
That is where I see oil prices next year, which will allow us to make some very nice returns all across the board.
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