Here's The Real Story Why Oil Prices Will Spike

We are in the midst of the worst oil bust in decades. The industry hasn't been in this bad shape since 1999, or perhaps as far back as 1986. With prices spiraling down to less than $40 a barrel, companies have been forced to slash their drilling activities dramatically, while cutting thousands of jobs.

In sharp contrast, consumers are rejoicing. The average gasoline price in the U.S. may fall below $2 a gallon later this year for the first time since 2009, according to AAA. That's spurred a boom in car sales, particularly for large trucks and SUVs.

Things certainly look great for consumers and horrible for producers, but don't get used to the current situation.

Production Falling Off A Cliff

The biggest culprit for oil's plunge starting in the middle of 2014 was the enormous growth in U.S. shale production. Output in the country had grown by nearly a million barrels per day for three-straight years up until that point, and the market simply couldn't absorb that breakneck pace of growth anymore.

Prices cratered from more than $100 a barrel in July 2014 to less than $45 in early 2015 (they later moved even lower to $37.75 in August of this year).

Crude Oil Prices

Compounding the oil market's problems was a surprise decision by the Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, to increase its production to punish and steal market share away from U.S. producers.

OPEC's strategy worked, and now U.S. output is tumbling on the back of reduced drilling, with daily production down 500,000 barrels from its high of 9.6 million barrels per day.

U.S. Oil Production (thousand barrels per day)

Source: Energy Information Administration

But low prices have taken their toll on the cartel as well, with some member countries faring worse than others. Saudi Arabia may be in a relatively comfortable position to weather the storm, but countries like Venezuela, Nigeria and Libya have seen their economies decimated as they struggle to maintain current production with significantly less cash coming in.

Demand Skyrocketing

At the same time that supply struggles, demand is headed the other way. According to the International Energy Agency, consumption is on track to increase by 1.8 million barrels per day this year, the fastest pace of growth in five years.

Source: International Energy Agency

That may come as a surprise to some people who expected the slowdown in China to have more of a negative impact on demand. These figures suggest that the benefits of lower prices on demand far outweigh any slowdown in China or other emerging markets.

As long as prices stay low, there's no reason to expect demand to slow down anytime soon. The record-breaking car sales in the U.S. are a reflection of that, and the new gas-guzzling trucks and SUVs that are bought this year will stay on the roads for years to come.

Prices To Rebound

If the outlook for supply and demand is so bullish, why haven't prices rebounded already?

That's because, as it stands now, supply continues to outpace demand. The big 2.5 million-barrel-per-day jump in OPEC production since the middle of last year―primarily from Saudi Arabia and Iraq ―has outpaced even the massive increase in demand.

Saudi Arabia Oil Production (thousand barrels per day)

Source: Bloomberg

Iraq Oil Production (thousand barrels per day)

Source: Bloomberg

But with OPEC now pumping full tilt, the cartel is effectively maxed out. As U.S. output heads lower, supply on a global basis is tilted to the downside.

If demand rises another 1.5 million barrels per day or more in 2016, that could finally shift the oil market into a deficit, lowering inventories and sending prices spiking.

The International Energy Agency expects demand to begin outpacing supply in the second half of next year. If that happens, prices must rise high enough to spur renewed investment in oil wells, particularly in the U.S., where new production can come online relatively quickly.

Pira Energy Group, a firm highly regarded for its energy price forecasts, says that it takes nine months for U.S. companies to bring new production on stream once it becomes profitable to drill again.

Analysts have a wide range of opinions on what price level will be required to incentivize U.S. oil companies to invest in new wells again. Pira suggests that oil will climb to $70 by the end of 2016 to encourage producers to drill. That would be a whopping 75% increase in prices from current levels near $40.

Risks To The Outlook

Of course, no forecast is without its risks. While the fundamentals seem to be lining up to send oil much higher a year from now, if demand disappoints due to much slower global economic growth than expected, that would throw a wrench into this bullish outlook.

On the supply side, the biggest threat to the outlook comes from Iran. The country promises to increase its exports next year as sanctions are lifted. If that happens, that could add another 600,000 barrels per day to global supply, according to the International Energy Agency, keeping the market oversupplied for a while longer.

Editors Note: ETFs that could spike along with oil include the Energy Select SPDR (XLE | A-90), the SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-58) and the Market Vectors Oil Services ETF (OIH | A-49).

Contact Sumit Roy at [email protected].