Why Oil Prices Will Rebound Before We Know It
Business + Economy

Why Oil Prices Will Rebound Before We Know It

REUTERS/Shannon Stapleton

Oil industry analysts have been engaging in a burning debate: Have prices hit bottom or do they have further to fall? Energy company CEOs have been voicing their views on the question as they report their quarterly earnings results. The International Energy Agency weighed in as well in a somewhat bearish five-year forecast released Tuesday, saying that oil prices will eventually rebound from current levels but still stay below the $100 a barrel mark. The group said global stockpiles would rise, putting prices under more pressure before spending cuts by oil producers kick in to ease the supply glut.

Here’s a safe call: Get ready for plenty of thrills, chills and volatility along the way. Let's take a look at five key lessons from energy company conference calls so far this earnings season, and at several stocks that will benefit from the next chapter that's about to play out in the ongoing saga of oil price volatility. 

Lesson #1: Oil rigs are going offline a lot faster than anyone expected

For energy stocks to keep going up, investors need a steep decline in North American production to drive oil higher. Producers have to shut down lots of rigs.

This is happening much faster than anyone expected, according to CEOs at three key energy services companies, which help energy companies produce oil. "The speed of the pullback by our customers is a bit unusual," Halliburton CEO Dave Lesar told investors in the company's Jan. 20 conference call. He chalked it up to panic among oil producers about having enough cash flow to pay their bills. Lesar estimated Halliburton customers have already cut their capital budgets by a whopping 25 percent to 30 percent, on average.

"This market is moving pretty quickly," agreed Baker Hughes (NYSE:BHI) CEO Martin Craighead in his company's Jan. 20 call. "I don’t want to say it’s overdone, but I’d say there’s a bit of drama in the marketplace." 

Related: Oil Price Could Bottom Out Around $20, Citi Says​​

In his company's Feb. 4 call, Atwood (NYSE:ATW) CEO Rob Saltiel described the drilling decline as the largest in nearly 30 years. "We’re seeing U.S. land drilling decline in a big way," he said.

All of this makes sense, because smaller projects in North America are much easier to shut down quickly than big offshore projects, says Jonathan Waghorn, who helps manage the Guinness Atkinson Global Energy fund (GAGEX). "You can drop a rig very quickly. You can drill a well and not complete it. You have various options for how quickly you can turn your spending off." 

Lesson #2: A sustained oil price rebound will happen…and relatively soon

The way things are going, North American oil production will decline faster than expected and we will see oil production decline before the summer, predicts Atwood's CEO, Saltiel. Markets often price events in about six months in advance. This explains why oil prices are already stabilizing and heading up, even though North American oil production is also still increasing.

Lesson #3: Oil won't go straight up when it rebounds

Will the oil price rebound be "V" shaped or "U" shaped? Seasoned industry execs at key energy companies definitely favor the latter. "We're not anticipating it being V shaped," says Anadarko Petroleum (APC) CEO R.A. Walker in his company's Feb. 3 call, echoing the view of several other CEOs in the space. 

One reason comes straight out of the history books. "There are four times when prices came down [a lot] over the last 30 years. Only once was there a rapid jump back," said BP (NYSE:BP) CEO Robert Dudley, in his company's Feb. 4 call. That was 2009.

Another factor: Though the rigs counts are dropping very fast, oil inventories are building up fast, even inside tankers leased by speculators just for this purpose. "When you have that much storage out there, it takes a long time to work that off," says Lamar McKay, who is in charge of energy production at BP.

One more potential snag: The much more efficient production of modern rigs, cautions Waghorn, at Guinness Atkinson. The rig count decline might take lousier rigs offline while more efficient ones stay on, or come online in the process. In that scenario, production might not actually decline fast enough, or it will happen in fits and starts. 

Lesson #4: Volatility will be the norm

The "U" shaped rebound in oil prices means investors should expect plenty of volatility in oil and energy stocks. But there's good news in this. It will make for some great trading, if that's your bent. Or it will give you opportunities to accumulate on pullbacks, if you're the buy-and-hold type.

Just don't get confused by the volatility. Oil is ultimately headed back up, energy executives say. "We don’t anticipate having a worse oil environment in the second half of year," Anadarko's CEO said, for example. "We believe that oil will continue to recover." BP assumes $80 oil in its budgets over the medium term, meaning several years.

Waghorn, at Guinness Atkinson, expects production to slow down enough to send oil to $70 by the end of the year, and then go up after that. Energy companies that would benefit the most are those with higher ratio of fixed costs to variable costs, which gives them the greatest operating leverage, he says. This means their operating profits go up at a faster rate as oil prices go up. 

Related: How Plunging Oil Prices Could Create Economic Upheaval

Producers of Canadian oil sands, projects with high fixed costs, fit the bill as long as the producers have solid balance sheets. Two good examples are Suncor Energy (NYSE:SU) and Canadian Natural Resources (NYSE:CNQ), says Waghorn, whose Guinness Atkinson Global Energy fund has outperformed competitors by two percentage points a year over the past 10 years, according to Morningstar. 

Brian Hicks, a portfolio manager at U.S. Global Investors Global Resources fund (PSPFX) says a more gradual "U" shaped oil price rebound is needed to get an oil price increase that lasts, since a rapid rebound would not shut down enough supply. Two energy stocks he favors in a price rebound scenario are Devon Energy (DVN) and EOG Resources (EOG). 

Lesson #5: Oil prices could spike at any moment

Mike Breard, an energy analyst at Hodges Capital Management, sees a high level of complacency towards geopolitical risk embedded in the low price of oil. For example, only one company — BP — made any reference whatsoever in its earnings call to the potential for violence, or the threat of it, to disrupt supply and spike oil prices. Breard finds this odd given the high number of potential problem spots, from Iraq and Nigeria to Yemen and Libya, just to name a few. "I have never seen the oil price so weak when there is the potential for so much unrest," says Breard. 

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has in the past suggested BP and OXY in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

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