By Kirk Spano
In June 2014, I wrote that the world was entering a “ peak oil plateau. ” A year later I declared that we are at “ the beginning of the end for the oil age. ” I received thousands of comments, emails and tweets, most stating I was wrong on both counts.
As history unfolds, the truth of both realities are becoming apparent to more and more people. Demand growth for oil has dramatically slowed and is within a decade or so of turning over and declining. Royal Dutch Shell (NYS:RDS.A) (LON:UK:RDSA) (AMS:NL:RDSB) recently stated that oil demand might peak within five years.
Ultimately, the advent of electric vehicles will kill half of oil demand over the next few decades. Large vehicles like trucks, planes, ships and trains will move away from petroleum-based fuels as well. In addition, new ways to make plastics, some already in production, will eliminate even more demand. By 2050, oil will be a niche product.
The final bull market in oil
The impending end of the oil age doesn't mean there can't be a bull market in oil prices (NYM:CLG27) . Much like an angry bull in a ring fighting for its life, oil is about to embark on a wild rise that takes many stocks with it.
The risk in oil is not of prices falling dramatically in the intermediate term, it's of a spike. While we could see some temporary price dips as traders focus on the details of supply cuts by the Organization of the Petroleum Exporting Countries, the clear risk is a blowout much higher.
There are several reasons oil prices are going to continue to rise. The recent OPEC supply cut and the rise of geopolitical risk are two important factors. However, the most important reason is the decline rate for deep-water oil. There is an annual production decline of about 3 million barrels a day from existing deep-water oil megaprojects. That's far more than the current supply-and-demand imbalance.
Because investors are wary of new long-term megaprojects, cuts of over $1 trillion in capital spending for such projects in 2016-2020 is unlikely to be replaced. There is also the implicit threat of OPEC pumping more oil that is likely to keep such projects from coming online indefinitely. That means the decline in deep-water oil production is terminal.
According to the EIA, even without the OPEC supply cut deal for the first half of 2017, supply and demand were going to be in balance in 2017 at about 98 million barrels a day. Whatever part of the supply cuts hold will cause a supply deficit that will lead to a minor reduction in record oil inventories (about 65-70 days worth of demand). That will put a floor under oil prices. I expect that we will see a price for oil around $70 per barrel by the 2017 summer driving season.
As time goes on, OPEC will increase production to account for any increases in demand around the world. The demise of OPEC has been greatly exaggerated. The group is still the global swing producer and price-setter for oil.
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In America, under President Trump, we will not let our shale go undeveloped and stranded. However, our production capacity isn't enough to be energy independent until there is more alternative energy production. Until oil demand falls, we will still need imports at least from Canada, Mexico and Venezuela. We might be able to produce the 1.8mbd that we currently import from Saudi Arabia; however, much beyond that is unlikely.
An important wild card that could drive oil prices even higher is the end of the “petrodollar.” Our 40-plus-year-old agreement with Saudi Arabia that oil will be sold in dollars is an important linchpin to being the world's reserve currency. When, not if, Saudi Arabia starts taking more currencies for oil, the dollar will take a hit and oil prices will jump. We were on a glide path to that eventuality. We might now be on a collision course as soon as in 2017, as I discussed in a recent article.
The combination of less megaproject investment and OPEC's low-cost production flexibility are about to lead us to higher-priced oil. The speed and severity isn't yet known.
4 American oil stocks to own
As oil prices continue to rise, many U.S. shale stocks will do very well again. Some already have largely priced in the scenario I have described.
Investing in the right U.S. oil stocks, in my opinion, will make investors market-beating returns for at least the next several years. There are many companies with massive debts and noncore shale-play assets that are still in trouble, though. Investors still need to avoid those because even with higher oil prices, they might not have enough time to heal themselves.
Among oil stock winners will be those with lower debt, have assets in the cores of the best shale plays, aren’t already fully valued and have a viable transition strategy to natural gas (which will have high demand for several extra decades than oil). Here are four companies that I own that are still priced to buy:
I have owned and traded Chesapeake (NYS:CHK) for years. This company is actually the least levered to oil in this group. Only about one-third of its production is oil, while two-thirds is natural gas. The company has aggressively restructured and sold off assets to overcome bankruptcy risk. It will either develop its Oklahoma SCOOP/STACK play or pull the money forward with a sale. That asset alone is probably worth about $1 billion.
Ultimately, I believe the company will be a low-debt natural gas play in about three or four years. After recent asset sales it is likely the third-largest natural gas producer in America.
This company (NYS:COP) used to be much larger but has downsized and positioned itself for the intermediate term. It has sold assets, plans to sell substantially more (likely overseas) and is focused on having a strong balance sheet. Its debt obligations are flexible and decreasing.
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Conoco has shifted to short-cycle unconventional drilling that alleviates long-term risks from the “end of oil.” It has ended all deep-water exploration — executives understand OPEC's threat. Management has positioned the company to succeed with $40-$60 oil. It will do much better in a higher-priced environment. With an oil price of $50, the company can fund capex out of cash flow, maintain its dividend and engage in stock buybacks.
It is the seventh-largest natural-gas producer in the U.S.
This company (NYS:ECA) has dramatically refocused itself the past few years. Its “core four” strategy has reduced its footprint to four main oil and gas fields. The key field now is the Permian, where it has thousands of low-cost drill sites. It has two very good natural-gas plays for the future. Its debt is much lower than a few years ago, and it is nearly covering production costs out of cash flow.
With higher oil prices, Encana will not only more than cover its capex and debt, but will throw off cash in the next few years. I believe this stock is deeply undervalued.
Occidental (NYS:OXY) has a very good balance sheet. Its debt-to-market-cap ratio stands at about 24%. About 60% of its production is from liquids. It pays a dividend of more than 4% at recent share prices.
The company is the largest producer in the Permian basin, which gives it a tremendous leg up on most competitors. Another strength is a strong chemical division that throws off cash. It also has midstream assets that can be sold for cash or spun into an MLP. The company's financial flexibility is impressive. Watch to see if it acquires more oil and gas assets, or looks to maximize profits intermediate term. The second option is a better path for investors.
Disclosure: Subscribers to Kirk's investment letter Fundamental Trends have previously been recommended CHK, COP, ECA & OXY. Certain clients of Bluemound Asset Management own CHK, COP, ECA & OXY. No new recommendations or transactions are planned in the next three trading days for the discussed securities. Opinions subject to change at any time without notice. Follow me on Twitter @KirkSpano for a free stock pick of the month or Facebook for a free stock pick of the month with analysis. Sign-up for a free monthly piece of research at Fundamental Trends. January's report is: "2017 - The Return of Volatility to Markets"