Description

In January 2015 oil traded at $29, the Van Eck oil services ETF (OIH) traded at $34.  Today WTI oil trades at $67 and OIH is $27.   In 2018 WTI is up 12% and OIH is down 9%.  OIH is 53% below its peak price of $57 in June of 2014.  Oil service companies have dramatically underperformed the commodity.  You would think either oil is going lower or sometime in the near to intermediate future OIH will appreciate substantially.  The top three holdings representing 40% of OIH are Schlumberger, Halliburton and National Oilwell. 

Since oil bottomed the financial press and major banks have been behind the curve in their analysis of oil supply dynamics and pricing.  In fact a few months ago, the major banks consensus range for oil in 2018 was around $50 per barrel and here we sit today at $67.  Consensus also forecast inventory builds in 2018 and that OPEC would need to extend cuts into 2019 to achieve normal inventory levels.  I think part of the reason oil equities are lagging the commodity so dramatically is that there is little faith that oil prices, longer term,  will hold let alone head higher.  

I will take the bullish side and lay out the current and future supply demand dynamics that argue for higher oil prices.  Once a shift in thinking occurs toward sustainable higher prices, oil services equities should have a significant cyclical bullish cycle. 

OPEC committed to rebalancing the oil market in late 2016, cutting about 1.6 million barrels a day.  Saudi Arabia and some other OPEC countries desperately need higher prices in order to stop the hemorrhage of foreign reserves and balance budgets.  The Saudis need oil at $85 to $90 in for this to happen.  What is remarkable with the quota system is that compliance is at 95% plus, something that has never happened before within OPEC.  Cheating has always been rampant with compliance at maybe 50%.  That shows just how serious the issue is for them. 

In January 2016, world inventories exceeded the five year average by 340 million barrels a day (mbd)  As of March 2018, that inventory hang has been eliminated with inventories now at 2.75 billion barrels.  Inventories are being drawn even in months which it is normal to have builds.  In the first quarter world inventories drew by 37 mbd while the normal build is 36 mbd. The big seasonal draw normally occurs in the last four months of the year.  2017 saw draws of around 120 million barrels.  Draws in 2018 could be even larger and draw headlines as inventories fall well below averages.  

There is a long and strong correlation between inventory levels and the price of oil (regression at 80%).    U.S. inventories, where a big part of the glut appeared, have, over the past 12 months, drawn 120 million barrels and now sit at 15 million barrels below average. 

Another factor that has accelerated the rebalancing is the implosion of the oil industry in Venezuela.  Production has declined from 2.4 million a day to 1.6 million currently.  With oil majors packing up and leaving, Chevron oil executives being jailed, and more and more oil workers quitting, the situation is more likely to get even worse. 

Supply and Demand Short Term

Oil inventories will likely move well below the five year average by the end of 2018 as seasonal demand pick up during summer and fall.    We could well have an oil price into the $80’s by the end of the year. 

It is surprising how little world spare capacity exists to bring on short term.   The market currently is about 700,000 barrels undersupplied and the market is currently growing at about 1.5 million barrels a day per year.  So in 2019 we could need 2.2 million barrels a day of additional supply.   OPEC may have 1 mbd in total with most of that coming from Saudi Arabia.   Non OPEC excluding the U.S. projection has been about flat for the last ten years and with about a $1 trillion in cumulative world capital spending from peak levels in 2014 the odds of this moving up are slim.  In the U.S., much has been made of onshore shale, but shale is unlikely to forestall or prevent a tightening of the global oil balance.   Let say the U.S. gains 700,000 bpd in 2019.  That leaves a potential deficit in 2019 of 500,000 bpd assuming OPEC produces all out, we have no political disruptions, and that Venezuela stabilizes. 

It is surprising that there seems to exist no risk premium given that that the worlds short term spare capacity in the range of 1 to 2 mbd.  For perspective in 1981 OPEC was producing 30 mbd in a 60 mbd world market.  Five years later they were producing 15 mbd.  The reduction effectively created 25% space capacity in the world market.  Today world demand is approaching 99 mbd and we have space capacity of 1% to 2%. 

Supply and Demand Medium Term

Looking at various forecasts, over the next five years global oil demand could increase 1.2 mbd a year, while non OPEC supply may grow 600,000 barrels per day per year.  Can OPEC provide an additional 3.0 mbd needed in 2023 under this scenario?.  There are obviously many variables but given aging elephant fields in the Saudi Arabia and some OPEC countries struggling to maintain current production, at a minimum, this is going to be a significant task and should bode well for a cyclical upturn in capital spending benefiting the oil services industry. 

Catalyst

Cyclical upturn in use of oil services based on higher average oil prices over the next five years.