Interactive Investor

Oil rally could make $80-plus

16th April 2015 11:14

Lee Wild from interactive investor

A 20% surge in oil prices inside a month has created quite a stir. Brent crude traded below $53 mid-March. It's now nudging $63, a level not seen since December, driven by a much lower-than-expected rise in US oil inventories and slowdown in production in the Bakken - one of the biggest US shale plays.

A question that both investors and market commentators alike have been asking and arguing about since the collapse in oil prices, has been how low can they go, and when will the recovery begin?

In January, UBS strategist Matthew Mish adopted a "lower for longer" mantra, as this downturn is driven by both higher supply and weaker demand. "This suggests the current selloff could take longer to play out and the eventual recovery could be more muted," he said.

He wasn't alone, and even Shell's assumptions, flagged as part of its purchase of BG Group last week, are for Brent crude at $67 per barrel in 2016, $75 in 2017 and $90 for 2018-2020.

Consensus estimates are for somewhere between $50 and $65 a barrel in 2015, and many experts predict a lurch lower before a very slow and modest recovery. Mark Henderson at Westhouse Securities, however, does not.

"Consensus is 99.9% of the time wrong," Henderson told Interactive Investor Thursday. "The oil price could be at $80-plus within the next six months. It could even be more."

"The fact that we have had a strong rally over the past few weeks despite negative press suggests that people are looking beyond that now and at what could happen."

Source: TradingView

A key tenet of Henderson's theory hinges on shale production in the US. A new shale oil well can produce an average of 600-700 barrels of oil a day. But these wells do not yield positive free cash in their first 6-12 months, even at an $80 a barrel. Output tails off very quickly, too, and production can halve over the next 6-12 months. It's why shale players must keep drilling fresh wells.

But the US government tips the domestic shale oil industry - responsible for about half of US output - to record its first monthly dip in production since records began in 2013.

"The US shale oil bonanza will be looked back on, like the US real estate bubble (and for that matter the Irish real estate bubble), as one of the great Ponzi schemes of the past few decades," says Henderson. "With huge liquidity (driven by record low interest rates and QE), banks have chased supposed one-way bets to their extremes and have now been caught by a 50% drop in the oil price."

"It is possible that US oil production could be DOWN by 1mmbopd within the next 9 months."

Much of the four million barrels of oil per day (mmbopd) increase in US production of the past four to five years has been driven by shale. However, in the past 10 years, non-OPEC production has grown by 1.5mmbopd net, which implies that without US shale, non-OPEC production has actually declined by 2.5mmbopd.

"If anyone was in any doubt that Saudi Arabia was in control of the oil market, now might be the time to rethink it. If they wanted, oil could be at $150/bbl by year end," reckons Henderson. "However, hopefully, it won't. The Saudis are not stupid; they don't want to kill the golden goose. They will try to manufacture a steady and unremarkable increase in the oil price back to the $70-80/bbl range by slowly releasing additional volumes onto the market."

"Markets do not necessarily behave in a rational fashion, however, and there will be short-term swings in sentiment, but I believe that oil prices could reach levels that nobody dares to suggest in coming months."

Henderson believes the best time to own E&P stocks is in the early phase of the recovery (see chart below). "I think we're close, if not already there." Henderson's top picks are still Tullow, Genel, Ithaca, Faroe, Lekoil, and Rockhopper.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.