The Energy Report: Marshall, before the Great Recession hit, we appeared to be on target for $150 per barrel ($150/bbl) Brent in mid-2008, and we were hearing forecasts of $200/bbl before the end of that year. But things have changed. I'd really like to get your fix on how you perceive energy markets have been altered over the past five years.
Marshall Adkins: For the oil market specifically, two massive structural changes have occurred since 2008. First, U.S. oil supply from horizontal drilling in tight shale formations has created a reversal of the four decade-long decline we've seen in U.S. oil production. When I say reversal, I'm not just talking a minor blip; I'm talking about erasing a 40-year decline within five years. This truly is a massive structural change to U.S. oil markets.
On top of that, in conjunction with the Great Recession, the world has figured out that there's too much debt, and most of the developed world is going through a deleveraging period. Historically, whenever you deleverage, you get subpar economic growth, and subpar oil demand growth. For the past five years, we've seen significantly lower demand growth for oil compared to the prior two decades. I expect that to continue, and I expect U.S. oil production to continue marching higher.
The combination of increased production and decreased demand growth has taken us from a world where we expected steadily higher oil prices, to one where we think there's going to be meaningful pressure on oil prices over the next several years, both in the U.S. and worldwide.
TER: Classic economic theory would suggest that if oil prices continue to decline, there will come a point when oil prices don't support further production. How far are we away from that scenario? Even with horizontal drilling in the shales, there has to be a floor in the oil price.
MA: Exactly. We're facing a structural problem right now with crude oil that should eventually take oil prices low enough to slow drilling. A year ago, you would have begun to run into economic problems at $75/bbl West Texas Intermediate (WTI) crude. Since that time, drilling and production efficiencies have continued to increase and service costs have come down. So I think that number might fall to $60/bbl before producers run into marginal economic problems. That said, the rig count and oilfield activity may slow well before you reach that economic threshold because as WTI comes down from $100/bbl to $85, $75 and then $65/bbl, your cash flows for the industry are squeezed. Oilfield activity tends to follow the cash flows. So as you drift down on the oil price, you'll see a steady decline in the oil-directed rig counts. That's not so much because the wells are not economic; they are economic. But the availability of free cash flow gets lower as you move down the oil-price spectrum.
TER: What about China? It must certainly be supporting the global price of oil right now. Would that be accurate?
MA: China has been the main component of global oil demand growth over the past decade. So if China goes into an economic funk or somehow slows its demand growth, then oil is in big trouble. The main thing supporting oil prices right now on a global basis is the fact that over the past 18 months, we have removed 2.5 million billions per day (MMb/d) from global oil supply. That's over 3% of the world's oil supply eliminated in a short period of time. Saudi Arabia has cut 1 MMb/d, Iran has been forced to reduce its exports by 1 MMb/d, and Sudan's and Syria's civil war strife has cost another 0.5 MMb/d. The staggering thing about this massive oil-supply reduction is that the world is still building oil inventories! Normally, if you get a 0.5% or 1% swing in supply, that's a huge mover of global oil prices. We've had 3% of oil supply knocked offline, and we're still building inventories. To me, that's an incredibly bearish statement that the market is ignoring.
TER: You've indicated that you see this downward trend continuing in oil. But over the past 52 weeks, we've seen the price of natural gas ascend 60%. My understanding is that if natural gas doubled from where it is today, it would still be cheaper than gasoline. Do you see natural gas supplanting oil as the primary vehicle fuel?
MA: No, not as the primary vehicle fuel anytime soon. For transportation, oil is still the most efficient and readily accessible fuel. Will natural gas begin to make inroads in the next 5–10 years? Yes, but it's not going to come anywhere close to replacing gasoline and diesel as transportation-related fuels.
However, we do expect to see a surge in U.S. natural gas demand on the petrochemical and industrial side. There is nobody in the world that can compete with the low-energy costs provided by U.S. natural gas when much of the rest of the world is using crude or extremely high-priced natural gas for energy-intensive industrial uses such as manufacture of fertilizer, methanol, petrochemicals or steel. This gives the U.S. a huge competitive advantage over the rest of the world.
TER: Do pure-play natural gas companies offer upside to investors?
MA: I think there's money that can be made in exploration and production (E&P) and services, but it's going to be very company specific.
TER: Where then are the opportunities for investors in energy?
MA: The opportunities to make money on the energy side are going to be mainly in the refining and infrastructure spaces. These sectors have a lot more profitability potential than the market currently believes. We're finding a lot of oil and gas right now, and it needs to be transported around the country and refined into a usable product, so infrastructure and refining are going to be profitable areas. The petrochemical sector, which uses cheap natural gas, is also likely to make investors money.
TER: So you're looking at midstream and downstream, roughly speaking.
MA: Yes: refining, infrastructure, master limited partnerships (MLPs) and, of course, the petrochemical industries. Companies that can take advantage of the cheap gas stream will compete favorably on a global market.
TER: Your specialty area is oilfield services. Does the services industry have pricing power?
MA: Let's talk two separate markets—international versus North America. In North America, which houses the majority of the investment opportunities in services, pricing for services has generally been falling. There is excess capacity in services across the board, and you've seen a sharp deterioration in pricing and margins over the past year. We think you'll continue to see pressure on pricing and modest pressure on margins in North America. Every subgroup will act a little bit differently, but we don't see the overcapacity that exists in most oil service areas in North America being solved for another year or two. On the other hand, we think activity with international and offshore services will see a steady improvement. You're seeing modest pricing power there. It's very modest, but certainly solid with slightly improving margins for both the international side and the offshore side.
TER: What about alternative energy? Are any of these going to take off and produce meaningful sources of power in the U.S. or globally?
MA: This takes us back to your first question. In a $200/bbl oil world, yes, solar and wind make sense. Many types of alternative energy make sense in a world where there is not enough oil or natural gas. The reality today, and certainly for the next five years, is that the lower-price environment for hydrocarbons that we foresee makes the alternative energies much less competitive. So, will we continue to get more efficient and cleaner in how we consume energy? Absolutely, and that's going to have a meaningful impact on our consumption of hydrocarbons. But looking at alternative energies, particularly solar and wind, they just don't make sense on a large-scale basis under a lower oil price scenario. Now, if you have off-the-grid areas where you can't get power lines, solar makes sense. But for the mainstream consumption of energy, the alternative energies at this stage don't make sense.
TER: Do you have any final thoughts to leave with our readers?
MA: I originally started in the industry as a hydraulic fracturing engineer 30 years ago. My pet peeve is these headlines from the popular press these days about this "newfound" fracking phenomenon that is extremely dangerous and could destroy the U.S. as we know it. Fracking is not new. This technology is over 60 years old and we've fracked hundreds of thousands of wells safely over the past half century. What's new is the application of fracking in horizontal and in multifracking stages, but fracking has been around for a long, long time. Some have made it out to be this big, new, evil and dangerous thing that's only recently emerged in the U.S. It's just not true.
TER: It has been a pleasure. Thank you.
MA: You bet. Thank you.
Marshall Adkins focuses on oilfield services and products, in addition to leading the Raymond James energy research team. He and his group have won a number of honors for stock-picking abilities over the past fifteen years. Additionally, his group is well known for its deep insight into oil and gas fundamentals. Prior to joining Raymond James in 1995, Adkins spent 10 years in the oilfield services industry as a project manager, corporate financial analyst, sales manager, and engineer. He holds a Bachelor of Science degree in petroleum engineering and a Master of Business Administration from the University of Texas at Austin.
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