It has been five months since I published my oil and gas price forecast for 2013, so it seems like a good time to update those calls.
I'll begin with oil. So far, my model is working beautifully. I expected Brent (the London benchmark price, which serves as a global proxy for oil prices) to average around $105 per barrel this year. After climbing from $111 at the end of 2012 to $119 during the first five weeks of 2013 and then declining to $97 in April, Brent moved back up to $105 as of May 20, the most recent price available from the U.S. Energy Information Administration (EIA). The 2013 average now stands at $108.72.
I expect moderate weakness in global oil demand to keep oil prices muted throughout the rest of the year, given continued economic malaise in Europe and fresh indications of slowing growth in China.
To be clear, I do not and never did subscribe to the "hard landing" thesis for China. At the same time, the country's pull on global demand isn't as strong as in recent years. All factors considered, I think it's likely that another dip in Brent in Q3 or Q4 will pull the average price down to my $105 target by the end of 2013.
In the United States, gasoline inventories are above normal levels and oil demand is at its lowest point in 16 years, primarily because U.S. consumers are still shrinking back from high prices for gasoline and diesel. The glut at the Cushing, Okla., delivery point for domestic crude, which new pipeline capacity had begun to relieve, bounced back up last week. For the next several months, the glut should continue to depress prices below where they would be if no shipping constraints existed.
My call for West Texas Intermediate (WTI), the U.S. benchmark, was that it would average around $90–$95 in 2013. So far it has stayed in the expected channel, between a low of $86 and a high of $98. This fits very nicely with my model of oil prices from last June, which suggested a price floor of $85 and a ceiling of $105 (in WTI terms). I suspect that the WTI ceiling has actually declined a bit over the past year, as the gradual shift to more efficient internal combustion engine (ICE) vehicles and public transportation proceeds. The economic "recovery" remains anemic and more evident in the stock market than in employment or disposable income, so I can't make the case for a renewed demand for gasoline and diesel. And while I am very bullish on electric vehicles for the long term, the data offers no evidence that they have taken a significant bite out of U.S. oil consumption yet; their market share is still miniscule.
On the whole, the data suggests that WTI could remain near current levels or weaken slightly throughout the rest of the year. As of May 20, WTI was at $96 and the year-to-date average was $93.88, putting it nicely on course for my price target.
The WTI-Brent spread now stands at $9 in round numbers, putting it just below the $10-15 range I expected for the year. And spare capacity is still at comfortable levels.
Since my model is working so well, I am letting my price calls from the end of last year stand.
So far, both the oil-abundance cheerleaders, including several high-profile bank analysts, and those following the scarcity thesis have been wrong this year.
In my December post I noted a spread of $30 between the low- and high-end calls, while Deutsche Bank said the spread was even wider at $50. In reality, watching the oil trade this year has been about as exciting as watching grass grow.
Few analysts -- and certainly, very few analysts who subscribe to the peak oil model, like me -- expected such a lackluster market this year. One must wonder why that is. Do they not understand the oil market? Is making such a call simply too boring to generate headlines and bring them fame (or notoriety)? Do they all suffer from ADHD, jumping at every hyperbolic headline about "Saudi America" and incipient energy independence, following every tick in inventory levels as if it were actually significant?
I suspect the latter. The 24-hour news cycle, the hyped-up market coverage on CNBC, the publish-or-perish rat race of the online publishing industry (especially the ones chasing gullible retail investors seeking the next "triple bagger!" penny stock oil and gas play), and the incessant propagandizing of the oil and gas industry are all designed to capture eyeballs and generate clicks, not to offer sound and well-reasoned analysis.
The best way I know of to understand the oil and gas market, and to trade it profitably, is as boring and routine as it has ever been: Turn off the chattering octobox on CNBC, ignore the hyperbolic headlines, dig up the data, then sit in a quiet room and analyze it from every side. That's what I do. It's what all good traders have always done.
Playing this oil market has been incredibly easy for those who had the discipline to understand my model and follow it: Scale in as oil approaches $85, and scale out as it approaches $105 (or now, perhaps $100). An algorithm blind to the daily trade could do it.
I hasten to add that I do not expect the market to remain this way forever. I still expect depletion to begin overwhelming new supply additions globally some time around the end of 2014 or the beginning of 2015. I have not seen any developments to dissuade me from that view -- no, not even the 2 million barrels of new oil (and natural gas liquids) supply from the U.S. tight oil boom. When that time comes, we will see another cycle like the one we saw in 2008, causing prices to jump, hit their heads against the ceiling, then crash back to the floor, and finally stagger back to their feet. But not yet.
Barring a major new geopolitical conflict, we should have fairly smooth sailing in oil prices for at least another 12 months.
Gas price update
My gas price forecast for 2013 was for it to approach $4 per million British thermal units (MMBtu) by the end of the year, having started at $3.36/MMBtu. That target was overtaken much earlier than I expected.
Apparently the smart money decided not to wait, and piled in to the long side of the gas trade. "Open interest" in the Henry Hub futures contract made a series of record highs in March. Gas prices hit a high of $4.38/MMBtu on April 19, almost exactly one year after it bottomed out at $1.82/MMBtu on April 20, 2012. Five days after that low, I suggested on Twitter that gas had likely bottomed, and subsequently bought exposure to gas through Southwestern Energy Co. (SWN), a low-cost shale gas producer, and the United States Natural Gas Fund (UNG), an exchange-traded fund that offers an easy way to access the futures market. (Disclosure: I still own both positions.)
Traders were quick to take those profits, however, and gas prices fell below $4 on May 3. They just broke above that level again on May 20 (again, the most recent price data available from EIA).
Accordingly, drillers are wisely taking a wait-and-see approach to committing more capital to drilling at the moment, with no major resurgence of gas production on the horizon.
As I mentioned in my last column, the growth trajectory of U.S. gas production stalled in January 2012 as drillers eased off of drilling for dry gas, which is unprofitable below $4, and moved on to "wet" plays containing more-valuable natural gas liquids.
For example, consider Ultra Petroleum Corp. (UPL). As gas contrarian and analyst Bill Powers tweeted yesterday, UPL is the lowest-cost gas producer in the United States by almost every metric, yet its production is falling as it reverts to drilling out of cash flow rather than taking on more debt. (As I detailed ad nauseam in 2011 and 2012, the U.S. "shale gale" was primarily driven by debt and land speculation, not actual profitability. See "The murky future of U.S. shale gas" and follow the embedded links to previous articles for a refresher on that story.)
As Powers pointed out in answer to my query, UPL recently wrote down its proved gas reserves in 2012 by 38 percent [PDF] because prices were too low (the write-down was based on $2.63 per thousand cubic feet, roughly equivalent to MMBtu). The company intends to continue reducing its drilling capex through the end of the year, and forecasts its production will decline [PDF] from just under 70 billion cubic feet equivalent (Bcfe) in Q1 2012 to around 57 Bcfe in Q4 2013.
By the way, Powers' new book on U.S. shale gas, Cold, Hungry and in the Dark - Exploding the Natural Gas Supply Myth, will be out in three weeks, and for those who are interested in some seriously nitty-gritty details about U.S. shale gas, I recommend it. I reviewed it and wrote a blurb for it. I'm more bullish on the future of shale gas than he is, but Powers has done some very useful and difficult work in lifting the skirt on this extremely opaque industry.
Shale gas king Chesapeake also expects its gas production to slip by 5 percent this year [PDF].
It's certainly possible that UPL and its peers will put money back to work in drilling if gas prices hold firmly over $4 in the coming months, which I think is likely. I'm not dumping my SWN and UNG shares yet, because I think they still have room to run.
But gas production has already been flat for nearly 18 months. If those companies wait much longer to resume drilling, the extremely high decline rates of the thousands of shale gas wells now in production will exert a serious undertow that will be hard to overcome. Remember, shale gas is a treadmill, and you have to keep drilling just to stay in place.
On the whole, I think the industry is much more interested in repairing its balance sheets and retiring its debt than it is in creating another value-destroying gas glut. I don't think we'll see gas prices substantially below $4 ever again (or if so, not for very long). We should view $4/MMBtu as an appropriate floor for continued operation, and I expect the gas industry will defend it.
On the other hand, I don't think supply will contract, or demand will increase, enough to substantively raise prices from current levels. With seven months to go in the year, I'm raising my end-of-year target, somewhat arbitrarily, to $4.50/MMBtu. To be honest, I just don't think there is enough data or clarity about the industry's intentions to peg a price much more discretely than in $0.25 increments, and gas passed $4.25 just last month.
So that's my mid-year update. No change on my oil call, and a 50-cent bump on my gas call. Not hugely exciting. I don't suppose I'll be getting a bunch of calls from editors looking for a sexy headline this week. But I might get the trade right, unlike the clients of Goldman Sachs, Morgan Stanley, Bank of America Merrill Lynch and Citigroup.
(Photo: The grass grows slowly while solar powers ahead in the UK. Photo by Chris Nelder.)