Monday, April 18, 2016

Fundamentals matter in the oil markets. Adding EOG Resources to the portfolio

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In their April 14, 2016 Oil Market Report, the International Energy Agency (IEA) forecasts that world oil demand will be pushing 97.0 million barrels per day by year-end. That compares to 94.8 million barrels per day in the first quarter.

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In their Oil Market Report, IEA reported that OPEC crude oil production declined by 90,000 barrels per day in March. Ongoing outages in Nigeria, the UAE and Iraq more than offset a further increase from Iran and higher flows from Angola. Supply from Saudi Arabia dipped in March, but held near 10.2 million barrels per day.

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The U.S. active drilling rig count has dropped off of a cliff to the lowest level in more than 70 years. On Friday, April 15 Baker Hughes (BHI) reported that there are only 351 rigs drilling for oil in the United States, compared to 1,609 in October, 2014.

In Canada, only 10 rigs are now drilling for oil. There are no areas in Canada where drilling new wells makes sense at $40 oil.

Most of the countries in Latin America are now reporting production declines.

The U.S. Energy Information Administration’s Drilling Productivity Report, which tracks activity in the seven largest producing regions of the country, says oil production from these key areas will fall by 114,000 barrels per day from April to May. Since there is now very little drilling activity outside of these key areas, it safe to say that from April to December oil production just in the onshore U.S. may decline by 1,000,000 barrels per day. Oil production in the Gulf of Mexico is expected to increase this year by 150,000 to 200,000 barrels per day to soften the overall U.S. rate of decline.


U.S. oil production peaked at 9.7 million barrels per day in April, 2015. By January, 2017 we’ll be fortunate to be producing 8.0 million barrels per day. Kiss those dreams of Energy Independence good bye.

It is never different this time as some commentators insist. Speculating on turns in commodity pricing is difficult because you can never catch the exact bottom. There is no email, memo, or text from Wall Street telling you when the bottom is in. 

We do know that when the price of a commodity goes below the marginal cost to produce it eventually supply will contract as no one is going to produce for a loss, at least for a long period of time. Demand actually goes up in many cases when the price of a commodity is down.

Nevertheless, it appears that supply destruction is finally taking place. I have to admit I was a year early in my predictions for a turn in oil prices. However, it now seems that US production is on the decline. Credit for new drilling is scarce and we have seen many over leveraged companies declare bankruptcy. 

We know the demand for oil will increase by about 1 million barrels per year every year. Couple this demand growth with natural depletion of 6% per year and add two years of substantial under investment and one can see how an oil price rise is in our future. I have held onto several of my oil speculations and I suspect they will be moving higher with the oil price. I am also adding EOG Resources (EOG) to my portfolio. 

EOG is the largest best capitalized shale producer in the US. It will survivor and it will prosper as it will be able to add acreage as other companies go bankrupt. 


What I really like about EOG is that they have set their business up so that they can break even at $30 per barrel. I suspect we could be at $60 per barrel by this summer. That is some decent gearing to the oil price if it in fact happens. 

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