Forecasting oil prices is a thankless task, yet investors are consumed with oil price forecasts. We do have a view on oil prices at Prism Investor, but before sharing it, let’s begin by picking on those who make a living trying to predict them.
In June 2016, Raymond James & Associates energy analyst Marshall Adkins published his forecast that the price of West Texas Intermediate crude oil would reach $80 per barrel by late 2017. Fast forward as I write this, the leaves are turning and this week we experienced our first snow of the season, both natural signs that late 2017 has arrived. Yet, oil prices remain in the range of $45 to $50, about the same level they were when Adkins made his $80 forecast over a year ago. Full disclosure: I’ve met Marshall a few times, read his reports and heard him speak at conferences. He is a very bright and personable guy, and I’ve always been impressed with the quality of his quantitative analyses and reasoned approach. But, like most oil price forecasters, he’s usually wrong.
I have had the fortune to meet many thoughtful and intelligent people in the industry in my career, and found at least one sober voice on on the topic of forecasting oil prices in Charles Cherington, co-founder and chairman of Argus Energy Managers. As a private equity investor focused on the energy sector, Cherington has a need greater than most to know the direction of commodity prices. In our discussions, he always struck me as someone with the sharp intellectual ability to analyze complex situations, but also possessing the wisdom to know the limits of a spreadsheet.
In an article he wrote for Oil & Gas Financial Journal in July 2017, Cherington penned, “All forecasters share a common trait: they are wrong. Some are only wrong most of the time and most are wrong all the time.”
Energy investors must have a view on commodity prices, because they impact the value of an oil company’s most significant asset – its oil in the ground – and they affect cash flow, profitability and the relative financial risk of companies up and down the energy complex. At Prism Investor, however, we are less concerned with the exact level and timing of future commodity prices than we are with being focused on the future direction of prices. That posture impacts how we view oil and gas stocks and decide what is important.
This is cyclical thinking, and students of business or commodity price cycles understand that the seeds of the next up-cycle are typically planted in the current down-cycle, and vice versa. As many an oil executive has said, “The best cure for low oil prices is low oil prices.”
“All forecasters share a common trait: they are wrong. Some are only wrong most of the time and most are wrong all the time.”
Let’s unpack that comment. Low commodity prices have drained the industry of cash flow and crippled returns on investment. One result of the current down cycle was the cancellation of $380 billion of investment in projects having the potential to deliver an estimated 27 billion barrels of oil, and that was in 2015 alone. Against the backdrop of rising global demand, however, the cancellation of projects combined with a lack of new significant discoveries is one “seed” that will eventually grow into a shortfall and help bring oil market fundamentals back into balance.
Delaying the day of reckoning between supply and demand, however, is the fact that the current cycle really is different from those of the past. The cancellation or deferral of capital investment in oil projects hasn’t been enough to bend the supply curve down and bring markets back into equilibrium as fast as some investors anticipated. Many institutional investors made bets on an oil and gas recovery in early 2017, believing the industry was at the bottom of a “V” shaped recovery. When an upward trend in oil prices failed to materialize, many hedge funds and mutual funds who bet heavily on the up-cycle that never came abandoned the sector altogether out of sheer frustration.
Those investors didn’t take into consideration the fact this cycle is different and the difference is shale. As Cherington pointed out, it is easy for U.S. operators to quickly hedge commodity prices when oil hits $50 per barrel or more, giving them the ability to lock-in attractive returns on drilling during the critical payout period early in a well’s life. Consequently, production from U.S. shale plays has been able to increase at a time when other oil and gas resources would be challenged by the economics.
When the day comes that oil traders recognize oil markets are reaching equilibrium, we anticipate oil prices will move up quickly and decisively, driving the value of energy stocks higher and faster than most expect.
Here is our view on oil prices. The industry is no longer at a cyclical low or high, the world’s current energy needs are being adequately supplied by existing levels of production and inventories, even at prevailing price levels that most in the industry would consider depressed. But demand for energy is rising. As the world’s population grows and as the middle classes of developing nations increasingly adopt an energy-intensive lifestyle, global demand for all energy sources will rise. Renewable energy sources will not be able to satisfy future demand alone, absent a technological breakthrough or two, because they are simply not as cost-effective or reliable as oil and natural gas. Because the oil and gas industry has cancelled or deferred hundreds of billions in long-lead projects to bring on future oil supply, when equilibrium is restored, the only two regions in the world that will be able to respond quickly enough to meet future demand are the U.S. oil shale basins and the giant oil fields of Saudi Arabia and UAE. At that point, because U.S. shale has a higher marginal cost to develop than large, conventional resources in the Middle East, the industry will need a higher price signal from the financial markets to stand-up more rigs in the U.S. to get product to market.
When the day comes that oil traders recognize oil markets are reaching equilibrium, we anticipate oil prices will move up quickly and decisively, driving the value of energy stocks higher and faster than most expect. This is the generational opportunity that presents itself to investors today. The problem is, no forecaster can mark that day on the calendar.