By Bryan Livingston
Managing Partner and CEO

Oil prices have been unsettled recently, dropping to prices last seen in August 2016, before gaining ground days later after new data showed a decline in U.S. production.

This recent dip into bear market territory is likely due more to speculation than to the fundamentals of supply and demand in the global and domestic oil & gas industry. Oil gained ground on July 18 after reports that Saudi Arabia was considering a 1 million-barrel-day cut to its crude exports.

We believe supply and demand will move toward a balanced market going forward, allowing prices to recover above $50 a barrel, although a sustained price of $60 to $70 a barrel may not be in the cards this year.

There are several issues at play that are causing this current bearish sentiment:

1. Global oil supplies remain fairly robust despite curbed production by OPEC, with Nigeria and Libya, two countries exempt from the OPEC cuts, as wild cards. Both countries have increased production in recent months, stoking fears that they could hinder a rebound in oil prices. More recently, Ecuador decided not to honor OPEC-imposed production limits any longer, which may lead to more uncertainty in the market.
2. On the domestic front, shale oil production has been rising, although the pace has slowed. Oil production from seven U.S. shale plays is forecast for a monthly rise of 127,000 barrels per day, to 5.475 million barrels a day in July, according to the Energy Information Administration, which has forecast increases each month of 2017 so far. Adding to the current bear market sentiment, the industry was surprised by an unexpected build in U.S. oil inventories in mid-June.
3. When oil prices hit $50, exploration and production companies began hedging a significant amount of their oil, suggesting they lacked confidence that oil prices would rise further. This speculation has driven down Wall Street’s confidence in the market. Many of these hedged production contracts are now expiring.

There are several reasons why we believe oil prices will recover:

1. Global energy exploration and production capital expenditures are expected to fall by 22%, or $740 billion, between 2015 and 2020, according Wood MacKenzie. When cuts to conventional exploration investment are included, the figure increases to just over $1 trillion. The effect will be a curtailment in global supplies while demand remains strong in many parts of the world.
2. OPEC, as least for now, appears committed to adhering to its production cuts.
3. The overall strong supply-demand fundamentals of the market will prevail. BP’s 2017 Energy Outlook points out that the world’s economy will nearly double in size between now and 2035, driven by fast-growing emerging economies as more than 2 billion low-income people see their prosperity improve. This rising prosperity will raise global energy demands although growth will be offset by gains in energy efficiency, BP notes. BP’s base case includes an expected 30% growth in consumption with a mix of fuels that becomes progressively lower in carbon.

Conclusions

The level of uncertainty in the oil & gas industry was evident in the latest Federal Reserve Bank of Dallas Energy Survey, which showed oil & gas business activity increased in the second quarter alongside uncertainty about the future. The survey covers the 11th district, which includes the oil-rich Permian Basin. The survey’s company outlook index posted a fifth consecutive positive reading but it’s notable that it fell 25 points to 20.3.

In a series of special questions focused on recent oil market developments, the majority of respondents to the Fed survey — 67% — expect the oil market to come into balance in 2018 or sooner with about a third expecting it to take longer.

We believe the industry’s fundamentals will ultimately win the day as the significant lack of capital spending begins to tamp down oversupply.

Capital Alliance Corporation is a Dallas-based investment banking firm with an extensive international reach and a 40-year history of providing trustworthy advice to private company shareholders who want to sell their businesses. Our team has deep operational and M&A experience across many sectors, including energy infrastructure.