The Best Way to Play Higher Oil Prices

Buy the Permian Basin

After several years of overproduction and weak prices, oil bottomed in 2016. At $51 a barrel, oil is up over 37% during 2016 and is trading almost double from the lows set in February. However, as we approach the end of this year, and with a large rally in the rearview mirror, where will oil prices go from here?

I’ve been a very vocal bull on oil since late 2015, stating that it was my favorite investment in for 2016 and it hasn’t let me down. I believe that oil prices will continue to head higher, due to a combination of factors, some well discussed and others not so much. In this week’s newsletter, I’ll detail why oil is headed higher, and how best to invest for the move.

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Let’s start with the known. Demand for oil is strong and expected to remain so. There is currently about 94 million barrels of consumption daily. This chart for the EIA shows how growth has been quite steady and consistent. I expect, with the pro-growth strategy coming under the Trump administration, and likely similar strategies in foreign governments taking root, these numbers will be exceeded. Bottom line? Demand is going up by around 1.5 million barrels per year.

Which brings us to the supply side of the equation. Most market prognosticators believe that crude remains in a widely oversupplied situation. However, look at the below chart, which shows oil production growth outside of OPEC.

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As the chart shows, since 2015, there has been limited growth in supply outside of OPEC. The biggest swing factor has been the US, which (along with Canada) is expected to have the most growth in production in 2017…we’ll discuss that later on. But, regardless, with demand increasing by over 3 million barrels per day since 2015, and supply growth outside of OPEC non-existent, in order for the world to be awash in oil in 2017, OPEC will need to have increased production significantly over the last two years. And, remain in a state of full production going forward. How has OPEC done?

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Well, as shown above, since early 2015, OPEC has increased production by about 2 million barrels per day. I’m using 2015 as my reference point as that was the time that the world realized oil was in oversupply and the market crapped out.

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Using that starting point, we’ve seen that demand has increased by 3 million barrels per day and supply has increased by 2 million barrels. Thus, 1 million barrels of oversupply has been taken out to the market.

This reduction in oversupply is confirmed by the following chart, which shows global production versus demand.

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Okay then, to this point I’ve detailed that crude is in an oversupply situation of about 1 million barrels per day. Why would crude go higher in this scenario? This is where the recent production cuts from OPEC come into play as well as my own estimates on US production growth (or lack thereof).

Starting with the OPEC announcement of late November when they announced a supply cut of 1.2 million barrels per day. This announcement alone takes all the oversupply out of the market. Throw in a commitment from Russia to cut 300,000 barrels per day and you’ve taken the market to undersupplied immediately.

Call me naïve, I actually think that OPEC will follow through with these cuts. My logic here is that it all comes down to Saudi Arabia. They have increased production the most and have by far the most to gain from higher prices. The bulk of the production cuts are their burden, but they are really just giving back the increased production of the last two years. Meanwhile, cutting their production by around 5% while seeing prices go higher by more than 10% is a huge cash flow win for them. I think they adhere to the cuts, which drives the rest of OPEC to adhere as well.

So, I see crude in an undersupply entering 2017 just based on OPEC’s cuts. But, there’s more. Here in the US, we have a large amount of “tight oil”, meaning that it’s generated by fracking. This kind of production has a very rapid decline curve, thus requiring significant ongoing drilling to maintain the volumes, much less grow.

Looking at the rig count in the US, however, you see that the amount of drilling is still well below the levels that drove production up during the 2010-2015 production boom.

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The number of drilling rigs in use now is still over 60% below its peak. In order to start increasing production here, this number needs to increase. And, I just don’t see oil companies going full bore drilling again, due to the recent pain they suffered. A lot of these companies nearly went bankrupt during the recent downturn…do you think they’ll leverage up their balance sheets rapidly to boost production so soon? I don’t.

Meanwhile, forecasts of increasing US production are mistaken in my opinion. I draw this conclusion from data published monthly by the states about their production. Looking firstly at North Dakota (you should check out this website, it’s very interesting), well production averaged around 30 barrels per day for a LONG time. Then the fracking boom came, and average production shot up to 105 barrels per day as the new wells had a huge initial production.

The trend here, however, is back to the norm. Average well production is down to 74 barrels per day and daily gross production for the state is down from 1.23 million barrels to under 1 million. With the minimal drilling going on the age of the average well is increasing rapidly versus the last few years. I think average production could drop down to under 60 barrels per day during 2017, which takes a couple hundred thousand barrels off the market.

Then there’s Texas. Check out the table below.

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During 2015, Texas managed to increase production even with the lower rig count. This is due to a combination of factors, but primarily caused by well completions lagging drilling. Here in 2016, production is down around 15% and the pace of the declines is accelerating. I think Texas will have a hard time increasing production in 2017 with the decline curves that are hitting current production. Thus, my estimate is for the US to be down in production overall in 2017.

Why is the US important? Because, if OPEC cuts and Russia holds firm (or cuts as agreed, but I don’t really trust them to do so), the only major producer with the ability to increase volumes is the US.

Remember that, due to the OPEC announcement, we are entering 2017 with oil in a negative supply balance. And, that the forecasts for consumption call for growth of over 1.5 million barrels in 2017. Thus, we could be looking at a deficit of almost 2 million barrels per day by the end of 2017 unless supply comes from somewhere. I don’t see it happening, which is why I have been and remain a very big bull on energy.

 Assuming I’m right, how should one play this? First off, I’m not a fan of the large integrated companies. I won’t go into detail now, but my opinion is that refining is going to remain under pressure and, thus, the large companies aren’t the best way to have a pure play on oil prices.

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Follow the oil producers and where they are drilling.

For me, I’m placing my bets in the Permian Basin. Which is where the producers are making their own bets. As you can see from the above chart, here in the US production is forecast to decline in all the fracking fields with the exception of the Permian Basin.

This is due to the Permian’s key similarity with Saudi Arabia. In both places when you drill a hole the question is not “will you hit oil?”, it’s “how much will you find?”. The Permian Basin is prolific and, with the increased drilling technology, producers there are getting great returns on their money. Check out the below slide from Pioneer Natural Resources.

Their Permian horizontals are 50% more profitable than the company as a whole. It’s this kind of margin that is causing drilling in the Permian to remain strong despite the lower prices and overall decreased rig counts in the US.

There are a number of high quality companies that are leveraged to the Permian Basin. Investors interested in playing higher oil prices and wanting to focus there, should look at the following stocks, in my opinion.

ESTE: (My favorite name in the space since their recent announcement of a merger with a large Permian producer and landholder.) Earthstone is an independent exploration and production company with operated properties principally in the Eagle Ford trend of South Texas and non-operated properties in the Williston Basin of North Dakota and Montana.

CPE: Callon Petroleum Company (the company) has been engaged in the exploration, development, acquisition and production of oil and natural gas properties since 1950. The company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture an independent energy company partially owned by a member of current management.

CWEI: Clayton Williams Energy, Inc. (the company) is an independent exploration and production company engaged in the exploration for and production of oil and natural gas primarily in Texas, New Mexico and Louisiana. The company is active in two core areas, the Permian basin and the Giddings area in south Texas.

FANG: Diamondback Energy is an independent exploration and production company headquartered in Midland, TX. Diamondback’s growth strategy is focused on the acquisition, development, exploration and exploitation of unconventional, long-life, onshore oil and natural gas reserves in the Midland basin and greater Permian basin in West Texas.

REI: Ring Energy, Inc. is a Midland-based exploration and production company that is engaged in oil and natural gas acquisition, exploration, development and production activities. Ring’s properties are currently focused in Texas and Kansas.

RSPP: RSP Permian is an exploration and production company focused in the Midland basin of West Texas. The majority of the company’s acreage is located on large, contiguous blocks primarily in the adjacent counties of Midland, Martin, Andrews, Dawson and Ector.

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