Playing Crude Oil’s Inevitable Rebound

Is the oil bottom in? And if so, how should investors position themselves?

Investors have been trying to call a bottom in oil for months now. From $80 to $60 to $50 to $40, there have been countless bottom calls along the way. Yet every time, they were wrong, and prices fell even lower.

Unsurprisingly, with a track record like that, the number of people willing to call a bottom in oil has dwindled. Sentiment is extremely bearish, with most analysts calling for further price declines in the short term.

Pickens Sees Oil Doubling

Yet amidst the overwhelming bearishness, there are a few brave investors who are doing it again—calling a bottom in oil.

Billionaire oil investor T. Boone Pickens recently told CNBC that he thought the bottom in prices was reached in January and that prices would double within 12 months.

Meanwhile, traders are pouring money into the perennial day-trader favorite VelocityShares 3X Long Crude Oil ETN (UWTI)—$356 million of inflows this year. The largest energy ETF on the market, the Energy Select SPDR (XLE | A-91), has also seen inflows this year—$150 million—and is up notably from its recent lows.

Are these bargain-hunting investors prescient, or simply foolish?

One Of The Largest Declines In History

As with anything to do with market forecasting, only time will tell whether oil has truly bottomed. But a look at the data reveals that the fundamentals of the market will turn; it's just a matter of when.

First, let's put the decline in oil prices in perspective. From a peak of nearly $108 in June 2014 to a low of $26.19, this has been among the two largest continuous declines for oil prices in modern history.

At 76%, the peak-to-trough drop in oil in the last year and a half is only a hair below the 78% decline seen during the financial crisis.

WTI Oil Price

But this downturn has been much more devastating for the industry. That's because prices started at a lower level ($108 compared with $147 before the financial crisis), and also because they've stayed down longer, with OPEC unwilling to cut output this time around due to the threat from U.S. shale producers.

Lowest Price In A Decade

But it's not just the outsized percentage decline that’s signaling that oil is a bargain. At $26, oil is quite simply dirt cheap. It's the lowest nominal price since 2003, and it's even cheaper on an inflation-adjusted basis.

Indexed to 1983 when WTI crude oil futures began trading, prices fell to just above $11 in January, close to the $10 level that has marked the bottom of other large declines throughout history. The one exception is the 1998-1999 period, when oil fell to a record inflation-adjusted low of $6.56.

Inflation-Adjusted Oil Price

Full Storage Concerns Fuel Bears

Of course, none of that is a guarantee that oil won't go lower in the near term. Most analysts acknowledge that prices at these levels are likely unsustainable, but the concern is that, as inventories continue to pile up, there will simply be nowhere left to store excess crude, sending prices to unimaginably low levels.

In this "full storage" scenario, prices would need to fall low enough to spur producers to shut-in existing wells, or in other words, to below the operating cost of pumping the oil out of the ground. That level could be $20, or it could be $15 or lower.

According to Pira Energy Group, onshore crude oil storage may run out by March or April, forcing any excess crude onto tankers offshore.

Production To Plunge

Of course, shutting-in existing wells is only a short-term solution. Longer term, the market will balance on the back of natural production declines. As producers drill fewer wells, output will follow suit.

Recently, Exxon and Chevron announced that they reduced their capital expenditure budgets for the year by 25%. Smaller producers―many struggling under the weight of high-yield debt―have cut their budgets by 50% or even more.

Worldwide, hundreds of billions of dollars worth of projects have been shelved or canceled due to the oil crash. A lot of that will be felt in the years to come; the fastest impact will be on U.S. shale oil production.

One of the largest shale oil producers, Continental Resources, says it expects its output to drop by 14% throughout the year on the back of a two-thirds reduction in capital expenditures. Hess Corp., a producer with operations around the world, expects its average 2016 production to be 8% lower for 2015 on the back of a 40% drop in cap-ex.

Many smaller producers with less financial flexibility may see even bigger decreases in their output as low prices take their toll. In aggregate, the Energy Information Administration forecasts that U.S. oil production will drop 700,000 barrels per day to 8.7 million barrels per day this year on the back of declining shale output.

U.S. Oil Production

That will go a long way toward balancing the market.

Demand At Record Highs

Meanwhile, on the other side of the equation, demand is hitting new record highs. After the largest increase in five years in 2015, demand will increase by another 1.2 million barrels a day this year, according to the International Energy Agency.

Falling supply and rising demand is unsustainable. At a certain point in the not-too-distant future, the oil market will shift into a deficit and send prices sharply higher.

Energy Equity ETFs The Way To Go

With all that said, we're still no closer to answering the original question of whether oil prices have bottomed out yet. Without a crystal ball, there's no way to know.

The winner of the race between fast-filling storage and a tightening supply and demand backdrop will ultimately determine whether $26.19 holds as the low.

Regardless, longer term, investors will likely do well buying energy ETFs and waiting for the turnaround in prices.

The Energy Select SPDR (XLE | A-91), the ETF that tracks the energy sector within the S&P 500, was recently down 50% from its highs.

The SPDR S&P Oil & Gas Exploration & Production ETF (XOP | A-70) was down an even chunkier 74%.

Returns For XLE, XOP Since June 2014

Unlike oil futures-based ETFs such as the United States Oil Fund (USO | B-100), energy equity ETFs don't have to deal with the negative drag from contango, and an investor can simply buy and wait for the carnage to end.

Certainly, the threat of bankruptcy hangs over the heads of many smaller debt-laden producers, but diversified ETFs such as XLE and XOP should be able to weather the storm and recover in the medium term.

Contact Sumit Roy at [email protected].