United States oil production is falling off a cliff. That's the message being sent by the latest data from the Energy Information Administration, the statistical arm of the U.S. Department of Energy.
According to the EIA's weekly report on the state of U.S. oil supplies, crude output in the country dipped to 9.12 million barrels per day last week, the lowest level since November 2014. Output is now down 493,000 barrels per day, or 5.1 percent, from the peak levels of 9.61 million barrels per day in June.
US Crude Oil Production
That's a stunning decline in a short period of time, suggesting that the yearlong plunge in oil prices and the sharp reduction in drilling activity are finally having an impact.
Of course, for an oil market that was severely oversupplied heading into this year, the drop in the U.S. production was necessary. The market simply could not continue to absorb the breakneck 1-million-barrel-per-day annual increase in U.S. output seen during the last few years.
Were it not for large supply disruptions in Libya and Iran in that period, prices would have plummeted a long time ago.
Of course, the oil market's problems were compounded by the Organization of the Petroleum Exporting Countries' shocking decision last year to raise production in the face of declining prices, as well as the weakest demand growth since the financial crisis in 2014, and the anticipated re-emergence of Iran into the world oil market.
In that context, it's clear to see why a downturn in oil prices and U.S. production was necessary to rebalance the market.
But like all commodities, oil is cyclical. There is no gentle way to recalibrate supply and demand, and inevitably, this brutal downturn in the industry will sow the seeds of the next run-up in oil prices.
On the demand side, the picture is improving rapidly. Global consumption will jump by 1.7 million barrels per day this year, the most in five years, despite the slowdown in China and emerging markets, according to the International Energy Agency.
On the supply side, U.S. production is tumbling, and may continue to do so as long as prices stay so low. Longer term, output outside the United States may be affected, as this year's reduction in investments begins to be felt across the global industry.
Surging demand and plunging output are a recipe for a tighter market and higher prices.
US Output Must Grow Again
Any bullish outlook for oil must be tempered by the fact that the U.S. producers still have a vast resource base of oil that they can tap into. That oil hasn't gone away, and drilling will quickly resume when prices rise to economic levels.
That said, going forward, the market needs U.S. oil. The output to satisfy the annual 1 million barrels per day or more of demand growth must come from somewhere. With OPEC effectively maxed out, the United States is the only country that can bring online significant volumes of production in a relatively short amount of time.
Energy ETF To Benefit
While the days of triple-digit oil prices are probably gone for the foreseeable future, higher prices will be required to incentivize drilling. There's also the possibility that prices temporarily "overshoot" to the upside if demand races too far ahead of supply when the cycle turns in 2016.
That all bodes well for energy exchange-traded funds, which have been beaten down throughout the past year.
The Market Vectors Unconventional Oil & Gas ETF (FRAK | B-29) looks particularly attractive after falling by more than half from its highs. With large positions in high-quality independent exploration and production stocks like EOG Resources and Pioneer Natural Resources, the ETF is well-positioned for any oil rebound.
FRAK holds a relatively concentrated portfolio, with the top 10 stocks making up 56 percent of the fund's holdings. That may discourage some investors from buying the ETF.
In that case, those investors may want to consider the Guggenheim S&P Equal Weight Energy ETF (RYE | A-73), which holds an equal-weighted basket of energy stocks within the S&P 500. The equal-weighting scheme gives the fund a greater tilt toward smaller-sized energy stocks, which should rebound faster than the industry giants that dominate the market-cap-weighted Energy Select SPDR (XLE | A-93).
Returns For FRAK, RYE, XLE Since June 2014 Highs
Contact Sumit Roy at [email protected].