Schachter Energy Report April 2017: Market Overview

Welcome to the First Edition of the Schachter Energy Report: April 2017

Complimentary Preview Issue

Enjoy the inaugural issue of the Schachter Energy Report FREE! Featuring the monthly Market Overview and April Company Reports from Birchcliff Energy, InPlay Oil, Pengrowth Energy, SDX Energy, Surge Energy, and Tamarack Valley Energy. Subscribe today to see up to date information on these companies and the many more on the Schachter Energy Report Company Coverage List.

A message from Josef Schachter

For years, after I appeared on TV, Radio or at speaking engagements, people would encourage me to publish a newsletter for individual investors to guide them through the commodity pricing volatility and focus them on the most attractive energy securities. Being in a persistent energy bear market, except for 3-6 month bear market counter rallies since 2014, I was reluctant to do so until now.

Looking into the future, I can now see a vibrant, 4-6 year Energy Bull Market on the horizon starting in early 2018. I feel it’s time to start researching and introducing investors to those stocks that should do well in this emerging new bull cycle. But first, we need to make it through one last, gasping and painful shake out sometime between now and year-end 2017.

As you read through the Outlook for Oil Prices I will explain the reasons for my macro and commodity price views and forecasts.

Over the next few months, we are going to introduce coverage on Large, Intermediate and Junior oil & gas companies and energy service companies until we have a list of 24 or 25 companies we feel have made the difficult decisions during the downturn and are well-positioned for success in the upcoming new Energy Bull Market.

Thank you for supporting us by purchasing a subscription. I hope you will find it a valuable tool as you consider your energy investment decisions going forward!

TO BUY OR NOT TO BUY

No one can predict the absolute top or absolute bottom of swings in the stock markets, or even for individual stocks. So to help in measuring the risk/reward we have created this traffic control system to highlight when it might be a good time to make your investments and to highlight the key measures we use to analyze the tradeoff between risk and return.

Energy Market Indicators

VALUE
SENTIMENT
TECHNICALS
OVERALL

 Green Light to Buy
Cheap Valuations, Sentiment not bullish, Technicals very attractive

 Yellow Light for Caution
Some wavering on parameters, or parameters not clear. Some stocks may be attractive, others not so

 Red Light to Stop or Sell
Parameters bearish, stay away, sell down, warning to wait for the next buy signal

Three variables must be taken into account to come to an overall energy sector rating:  Value, Sentiment and Technical conditions of the sector.

Value means that companies in general have attractive valuations versus historic financial measures such as; low operating and finding costs, growing production, cheap on a price to net asset value or book value, stable and improving balance sheets and meaningful plans for future growth within set foundations depending upon the commodity prices and for energy companies, their best drilling inventory. Companies need great people, project upside and strong financial capacity to succeed. These are the mix of fundamentals needed to be a successful energy company in the current volatile commodity price environment.

Sentiment is trickier to document but is still measurable.  Bull cycles are fed by greed! Greed is fueled by speculators who drive stock prices higher than the fundamentals warrant as they are prepared to discount even higher commodity prices. The S&P Percentage Bullish Index indicates where we are in the sentiment cycle. When the indicator is above 90% it highlights a market in frenzy and a top is likely shortly thereafter. When the indicator is below 10% bullish it indicates a high level of fear, and it is precisely when fear is at its highest that it is the best time to invest. Major bottoms have been seen when bullish levels have been at 5% or less. The lowest index we have seen has been a 2% bullish level which coincided with the commodity price lows in 2009 and in early 2016. These turned out to be table pounding buying opportunities. We expect to see another such table pounding window later this year.

Technical indicators: We use technical analysis tools to identify high and low risk entry points for the sector and for individual stocks. We look to see if the current stock price is cheap or expensive versus historic measures including energy commodity prices. There are many tools to use so this measure has a more judgmental perspective. Some of the indicators we look at as part of our tool kit include trend lines, moving averages (MACD) and Relative Strength Indicators (RSI).

When these three factors become aligned and all give a green light, ones chances of making low risk, high reward investment decisions are improved.

CLICK ON ANY IMAGE TO ZOOM IN

NEAR TERM OUTLOOK

for WTI Crude Oil Prices

1. OPEC has cut production by 1.2Mb/d but this still is adding to the glut on the market.

There are many conflicting and complicating factors that come into play when trying to forecast the price of oil;  worldwide production levels versus demand, where production is rising and where it is falling, storage levels now versus historic ranges, war or risk premiums and lack of transportation. Political posturing, insurgent attacks in far away countries, and local pressures on OPEC and non-OPEC producing countries all add to the volatility and unpredictability of oil and natural gas prices.

Here is my rationale for believing that there is going to one final dramatic plunge in oil prices to end the current bear market.

The chart at right shows that in March 2017, OPEC produced 31.9Mb/d, a decline from February 2017 of 153Kb/d and down 1.2Mb/d from the high of Q4/16, thus achieving OPEC’s goal of cutting 1.2Mb/d in Q1/17. In their monthly report the interesting information was that Saudi Arabia raised production by nearly 42Kb/d and that Iran and Iraq both had slightly lower production levels than February. Libya which had targeted to raise production to 800Kb/d from 683Kb/d in February failed to do so as militants continued to disrupt the export terminals. Recent articles continue to talk optimistically that this will be resolved successfully but so far the insurgents have proved these claims false.

OPEC Crude Oil Production

Source: OPEC Monthly Oil Report – April 2017

CONCLUSION

OPEC cutbacks are insufficient and storage continues to build

The call on OPEC in Q1/17 according to OPEC itself was 31.58Mb/d and yet, even after their 1.2Mb/d cut, they produced 32.01Mb/d, resulting in excess production of 430Kb/d throughout the quarter. As a result, a total of 38.7 Mb had to find a home in the nearly full storage market. It appears from the US Energy Information Administration (EIA) data that this surplus found a home in US storage facilities.  See the Balance of Supply and Demand Chart below.

Balance of Supply & Demand

Source: OPEC Oil Monthly Report – April 12 2017

2. Crude stocks are still building, especially in the US.

Inventory builds in the US are expected to continue into the May/June period before the refineries start to pull down stocks to create the more stringent environmental summer grades of product. We therefore expect that over the next 4-6 weeks commercial storage will rise to record high levels and that the concern about how much storage remains will become the focus of the markets.  We became bearish in 2014 as inventories in storage rose rapidly, highlighting OPEC’s mistake in glutting the markets. The EIA, in their report on April 11th, expects a continuation of inventory build on a worldwide basis, versus the optimistic views of the OPEC and other bulls that supply and demand will balance in 2H/17, and that a meaningful decline in stocks will occur thereafter. We support the EIA’s bearish view that unless OPEC not only extends the 1.2Mb/d cut through the end of 2017, but adds an additional 1.5-2.0Mb/d to this cut over the next few months, then the glut and full storage will create another tsunami for oil prices.

Crude Oil Stocks (millions of barrels) and Days of Supply

Source: EIA weekly information April 12, 2017

CONCLUSION

US Crude within 15 – 20 million barrels of maximum storage

World Liquid Fuels Production and Consumption Balance

Source: Short term Energy Outlook, April 2017

Storage in the US is filing up and concern about how much more crude oil can be stored will become the focus of the markets if OPEC does not make meaningful additional production cuts in the near term. While the second most important demand period of summer driving is just ahead in July and August, the shoulder season of September, October and November is also ahead. With a timeline of 90 days for OPEC cuts to be seen by importers, additional cuts need to occur in the next 3 months, or a more massive glut problem will be seen in the fall shoulder season, meaning the lows for crude prices could be delayed into later this year with downside price pressure even lower than our current forecast of US$30 – $34/b.

Last week Cushing inventories were at 68.6Mb.  There is speculation that there might be 72-74Mb of effective capacity at Cushing, Oklahoma but this has never been tested before. If the continued, and very likely rise, in US production is seen over the next few months, this may become a real problem and not just a theoretical one.

3. US Production growth is rising sharply with WTI holding around US$50/b

US production last week rose by 40Kb/d with 17Kb/d coming from domestic production and 23Kb/d from other sources including renewable supplies. Total US Petroleum Supply rose to 9.25Mb/d.

What is significant is that US production has risen 850,000 b/d from 8.4Mb/d in Q3/16 in just under 8 months. Technological innovation, pressure on the service sector to lower prices and operational changes all helped to provide adequate incentive to lift production meaningfully with crude oil prices being range bound around US$50/b.

CONCLUSION

US production rising sharply in US$50 price environment

US Total Crude Oil Production

(‘000 bbl/d, EIA)

Source: Wall Street Journal, April 20, 2017

The EIA expects oil production in the US to rise by 124Kb/d in May 2017 with the largest rise in the active drilling Permian basin. North Dakota, with the Bakken oilfields, is now seeing more active drilling and with the new Dakota Access Pipeline starting up, this area should see a sharp rise in production in coming months. This week’s Baker Hughes rig count shows North Dakota with 44 active rigs up from 26 last year. Bakken new well production is estimated at 1,068 barrels per well per day. The most prolific basin remains the Eagle Ford with 1,448 barrels per well per day.

New Well Oil Production/Rig

(barrels/day)

Source: EIA Drilling Activity Report April 17, 2017

Oil Production

(thousand barrels/day)

Source: EIA Drilling Activity Report April 17, 2017

4. New oil pipeline infrastructure will mean an acceleration of US production growth.

With the new Dakota Access Pipeline expected to ramp up interstate deliveries starting on May 14th, according to a recent release by the US Federal Energy Regulatory Commission (FERC), producers in the area are drilling up production quickly so that they can fill the 470,000 b/d pipeline. Data from North Dakota’s Pipeline Authority, established by the State Legislature in 2007, shows that rail export volume had peaked in late 2014 at over 800Kb/d and had fallen to only around 300Kb/d in early 2017. With companies waiting for the Dakota access line to start up, production from the Bakken had fallen from over 1.2Mb/d to 1.024Mb/d in April according to the EIA. With the line having been filled to Chicago and the FERC approval to start selling interstate, the upside in net volumes could be over 300Kb/d even if rail volumes fall by 170Kb/d, which may be way too high an assumption. The net increase of 300Kb/d or more would raise US domestic production quite quickly to new highs and spook energy bulls and OPEC’s plans.

As other pipelines come on, even more stranded oil should come on stream.

CONCLUSION

New pipeline additions in the US will add materially to US crude oil production

Estimated ND Rail Export Volumes

Source: North Dakota Pipeline Authority – January 2017

Bakken Region Oil Production

Source: EIA Drilling Productivity Report April 2017

5. OPEC needs to cut at least another 2.0Mb/d to see inventories decline in 2H/17

OPEC needs to cut its current production levels substantially if it is to stop the growing build in world crude stocks that at some point will not find a home and the marginal barrel from OPEC thereafter would trade at a lower and lower price. With cost cuts, a price point in the US$50’s helps non-OPEC to bring on substantial new volumes and allows non-OPEC to capture all of the annual world-wide demand growth. OPEC needs to balance supply and demand or face severe price pressure consequences. If OPEC members are desperate for funds, a price war will restart and crude prices will fall much lower than our current forecast of US$30-$34/b.

Actual OPEC Crude Oil Production

vs. Stated Production Quota

Source: Wall Street Journal, EIA

CONCLUSION

OPEC needs to cut 1.5-2.0M barrels more if they are to balance world supply and demand

Historically, to re-balance supply and demand, OPEC has needed to be the swing producer and lower production 2-4 times, taking production down a total of 3-5Mb/d. It took three cuts to get to 3Mb/d in 1998-1999, four cuts totalling 5Mb/d in 2001-2002 and 3Mb/d in 2008-2009 in two big cuts. This time, OPEC needs total cuts of >3Mb/d and so far the 1.2Mb/d cut for the first six months of 2017, with a plan to extend the cuts into the end of the year, has failed to end the growth in world crude inventory build. More cuts will be required to re-balance supply and demand and stabilize or strengthen the price of WTI.

6. The Upcoming crude oil price plunge and stock market impact expected

As crude storage fills up during the current spring shoulder season, we expect WTI oil prices to retreat unless there is some extraordinary black swan event. There definitely are black swans out there, from a terrorist attack on OPEC production facilities to a strike or civil breach in Venezuela that would shut in the country’s nearly 2.0Mb/d of production. However, if no such event occurs then watch for the important downside breach at the critical level of US$46/b in May or June. We remain in no-man’s land between US$46 to US$56/b. If WTI Oil rises above US$56/b then the bulls are right and we are wrong. If it breaches US$46/b on the downside, then the bulls will have to admit defeat.  The preponderance of the data supports our bearish posture.

Our current view is that the price of crude oil will fall to the lows of US$30-34/b by the end of Q2/17, however, machinations by OPEC could delay this into year end. If so, the downside would be even greater than our current forecast, and the lows could equal or go below those of Q1/16. Once this shakeout occurs, we believe the ingredients of a new energy bull market would be in place. The period of 2018 to 2022 and beyond could provide another meaningful and rewarding energy bull market cycle.

WTI Crude Oil Prices

Source: www.stockcharts.com April 18, 2017

CONCLUSION

For the bulls, a rise above US$56 means they are correct and if the price falls below US$46 the bears are correct

If OPEC non-quota members, Libya and Nigeria, are able to turn shut-in production back on as they resolve internal conflicts, over 500Kb/d will be added to OPEC’s production levels and make OPEC’s attempt to pull worldwide inventories down a non-starter. Additionally if Iran and Iraq raise production in 2H/17 as they are forecasting, then Iran will go from 3.8Mb/d in March 2017 to 4.0Mb/d and Iraq will go from 4.4Mb/d to 5.0Mb/d. These two countries are desperate for funds as they are fighting existential wars which, when won, will need enormous amounts of capital to rebuild the economic infrastructure in Syria, Iraq and Yemen. Overall, they could add 800Kb/d which would severely glut the market and drive crude prices to a lower level than seen in Q1/16.

This is the most bearish case and we see the possibility of this painful event occurring. If so, the low for crude in 2017 will not be seen in June 2017 but closer to year end and would be climactic in nature.  In this situation, energy stocks would get pummeled and a table pounding buy window would develop similar to the wonderful buying windows of Q1/09 and Q1/16. In this case, the S&P/TSX Energy Index would fall to below the Q1/16 capitulation level of 125.84.

WTI Crude Oil

Source: www.stockcharts.com April 18, 2017

The S&P Energy Sector Bullish Percentage Index has been a very useful tool to confirm tops and bottom in the energy sector swings. Whenever it reaches over 90% it is in lofty territory and near exhaustion of the bull run, and when it falls below 10% it is indicating a near term exhaustion of the selling pressure.

Currently we are at 38% and we expect a final plunge to below 10%, maybe even to below 5% to set up a confirming indicator of a bottom and the start of a new energy bull market. As you can see from the chart below we have seen repetitive swings from one extreme to the other and we intend to use this tool to help us in guiding our subscribers. When the indicator gets to the extreme low we envision, we will focus our readers on the many great energy and energy service stocks that should be considered for the upcoming lengthy new bull market.

S&P Energy Sector Bullish Percent Index

Source: www.stockcharts.com April 18, 2017

LONG TERM OUTLOOK

Why we see a length energy bull market lasting at least 4-6 years starting in 2018

The energy sector is one of high returns in robust commodity prices. This attracts capital rapidly and in amounts in excess of actual need, resulting in the bidding up of asset prices and the spending of more and more money on projects, creating inefficiencies and a lack of capital spending control. In the period between 2000 and 2014, spending rose fivefold from US$160B per year in upstream oil and gas spending to US$780B. In 2016 this spend fell by over US$300B to US$420B resulting in the inability to fund enough exploration and development to replace decline rates.

In the energy bull market of 1974 to 1981, the non-OPEC energy industry had Proven Reserve Life Indices (P RLI) of 14-16 years. This fell during the lengthy bear market which lasted from 1982 to 1999 to Proven Reserve Life Indices of 10-12 years as companies could not invest enough to replace declines and grow production. The focus of energy companies in this painful bear cycle was on getting as much production on stream as fast as possible and gain as much cash flow as possible, the sooner the better. The Asian boom led by China from 1999 to 2008 was a very rewarding one for the industry and investors as the price of crude skyrocketed from below US$20/b to over US$147/b. The industry shrank the Proven Reserve Life Indices even further, to the 7-9 years level, on the expectation of high commodity prices allowing the industry to replace reserves with high commodity prices covering up the inefficiencies of the industry. Stock investors did not care about the inefficiencies of the industry such as overpaying for land in hot plays, or not caring about the cost of drilling or services, as stocks rocketed higher. The S&P/TSX Energy Index rose from 106 in late 2002 to 470 in Q2 2008, providing a wonderfully profitable ride for investors.

In 2008 we stared the latest bear cycle which has had some sharp swings with lows in Q1/09 of 174 for the S&P/TSX Energy Index to a recovery high of 370 in Q1/11 to a low of 126 in Q1/16, then the recent bounce to 231 in late 2016. The final plunge is now underway. During this bear market the Proven Reserve Life Indices for most conventional energy companies has fallen to the 6-7 year level for Canadian and American conventional energy producers.

The treadmill to replace reserves is now at an extreme, which will set up the next energy bull market. With decline rates or depletion of reserves at over 25% for most of the industry and over 35% for rapidly growing shale producers, the amount of funds needed to replace production is prohibitive below US$50/b. If we are right about the current glut getting worse and that crude prices will fall sharply or by over US$20/b from the recent mid-US$50’s highs, then companies will be showing declining production comparisons in coming quarters and some of the companies with high debt loads may not survive. As we see the ‘Dome Petroleums’ of this cycle fall by the wayside, the ingredients for the upcoming new energy bull market will be sown. We need to see the hot speculative money get burned and run away from the sector. With the removal of high yield debt, private equity and other speculative pools, rational behavior should return to the sector and a vibrant new energy bull cycle will start. It will get silly again in 4-6 years and then we will have to be vigilant in protecting the capital gained during the rational initial robust years of the new cycle.

Energy Bull & Bear Cycles 1973 – 2017

Source: Schachter Energy Research Services and EIA data

Upside in the new energy bull market cycle – Why invest in the upcoming new energy bull market cycle?

If we are correct that the final capitulation drives the price of crude down to the low US$30’s or less and the S&P/TSX Energy Index down from the current level of 197 to the 120 level, this would be the starting point for the new multi-year energy bull market.

In 2018 oil prices may be back to the mid-US$50s by the summer and to US$70-75/b in winter 2018-2019. Heading into 2020, if there are any disruptions in supply from the Middle East and a risk premium returns, we may see crude prices again trade over US$100/b. Over the early years of the next decade we expect to see prices range-bound in the US$100-120/b area unless we see another recession and prices retreating to below US$35/b or if there is a supply disruption from a material OPEC supplier like Venezuela or Nigeria which would drive prices back to the record high of US$147/b as seen in Q2/08.

For stocks, we see the S&P/TSX Energy Index rising from the ashes of the 120 level to the 220-250 level by the end of 2018 and over 350 by the start of the new decade. If there is a frenzied period at the end of the cycle due to a supply disruption or an OPEC risk premium issue then the Index could run up and exceed the high of Q2/08 of 470.

We therefore see the price of crude rising 4-5 times in the next energy cycle and for stocks to do nearly the same. The infrastructure stocks and integrated companies will do well and provide an attractive dividend but will be under-performers against the sector index lift. We will be focusing on companies in both the energy and energy service sectors that will grow faster than average and, for the E&P area, have attractive exploration upside that, if successful, would mean stocks would be able to go up 8-10 times during the cycle.

We note our support of Centurion Energy (CUX) in 2002 which went from producing over 1,000 boe/d to over 30,000 boe/d as they succeeded with the drill bit in Egypt. The stock rose from C$0.66/share to C$12.00 in 2006 when it was taken over. So far, one of our covered companies is following this magical ride, as SDX Energy (also in Egypt) has made a material natural gas discovery. The stock has lifted from $0.33 per share when they spoke at the World Outlook Financial Conference in early 2016 to its April 21 close of $1.14/share. The management team has delivered, taking production from just over 1,000 boe/d in early 2016 to over 4,000 boe/d currently and plans to grow production to over 6,000 boe/d by late this year. When the new SD-X1 discovery is fully developed by Q2/18 (if all regulatory approvals are met and equipment obtained) they could be producing over 12,000 boe/d by summer 2018. This is the kind of junior energy stock that we want to be involved with and bring to you, our subscribers.

CONCLUSION

If crude goes down to the low US$30’s or less and the S&P/TSX Energy Index down to the 120 level, this would be the starting point for the new multi-year energy bull market
2017-07-27T15:09:46+00:00 April 26th, 2017|Market Overview, SER|