Even though oil prices have wobbled a bit over the past couple of months, optimism has returned to the oil market. Producers in the U.S. have ramped up investment spending to such a degree that Dave Lesar, the CEO of oil-field services giant Halliburton (HAL 1.93%), quipped last quarter that "animal spirits have broken free and they are running." Further, Lesar noted that "customers are excited again, and our conversations have changed from being only about cost control to how we can meet their incremental demand."
However, when market conditions get this bullish, it's easy to forget what might go wrong. Here are three things, as examined by our Foolish experts, that could quickly derail the oil market recovery and take oil stocks down with it.
Lower for longer could last a while
Tyler Crowe: When oil prices started to crash, one of the phrases that integrated oil and gas executives commonly used was "lower for longer." I think they were saying it at the time to get some other companies to back off their capital-spending plans, but they were right. The more than two-year decline in oil prices was the worst energy market crash in over 30 years. If you look at the last time oil crashed this hard, there are a lot of parallels today that suggest we could be in for a sustained period of lower-for-longer that could drastically affect the rates of returns for investors.
This most recent crash shares a lot of similarities with the 1981-1986 decline in oil prices. In the lead-up to both price slides, there was a sustained period of high oil prices that fostered both a sense of unease that the world was running out of oil and a rush of innovation in the oil patch. In the early '80s, that technological revolution was offshore drilling, which allowed us to unlock the billions of barrels in places like Alaska's Prudhoe Bay and Mexico's Cantrell field. Today, that new source we have unlocked is shale, and the implications for this discovery could be just as large. Consider this: The ability to tap shale wells economically means that the Permian Basin in West Texas could hold as much as 160 billion barrels of recoverable oil, as much as Saudi Arabia's legendary Ghawar field.
Once oil producers started to realize the potential of offshore drilling, it significantly lowered prices and forced companies to rapidly reduce costs. Sound familiar? That technological discovery and subsequent optimization of that technology was a considerable factor in the low-oil-price environment of the 1980s. With so much oil at the tips of producers' fingers, there was little fear that we could be headed for a shortage.
At today's prices, a decent amount of shale producers can turn a profit, albeit a modest one. The knock-on effect of shale generating a small rate of return, though, means that the global marginal cost per barrel has declined significantly and is likely to lead to a sustained low-rate-of-return period for the industry.
History never repeats, but it does tend to rhyme in cyclical industries. If we can draw any lessons from the last time we saw something in the oil patch, investors shouldn't expect high rates of return for a while.
Forecasting isn't exactly a science
Matt DiLallo: Graham Stein said: "Energy forecasting is easy. It's getting it right that's difficult." That's why investors can't take projections too seriously -- more often than not they don't come to fruition. That's particularly true for oil demand forecasts, because they tend to ebb and flow with the global economy, which can change on a dime.
For example, the International Energy Agency (IEA) initially expected that oil demand would grow by 1.4 million barrels per day this year. However, it recently cut that forecast by 100,000 barrels per day because of tepid demand. In fact, oil demand growth came in 20% lower than it expected during the first quarter, which was a big reason oil supplies continued piling up in storage despite OPEC's best efforts. Meanwhile, the IEA remains worried that oil demand growth could weaken further because of slowing economic growth in Russia, India, South Korea, the U.S., and in some Middle Eastern countries.
If demand continues to come in slower than expected and OPEC doesn't extend its output cuts past mid-year, then it could put significant downward pressure on oil prices. That would be bad news for a shale driller like Whiting Petroleum (WLL), which plans to outspend cash flow to increase production 23% by the fourth quarter of this year. In Whiting Petroleum's case, it needs oil to average $55 per barrel this year to break even. However, crude has been below that level all year, which could prove problematic for Whiting because it means the company has added debt to an already stretched balance sheet. The company might therefore need to cut back spending to avoid digging itself into a deeper hole, considering it has $1.5 billion of debt maturing over the next few years.
Whiting is just one of several oil stocks that could face a day of reckoning later this year if oil demand takes an unexpected dive.
OPEC changes course (again)
Jason Hall: One of the biggest positives for oil stocks in the past several years was OPEC's recent agreement -- which ended up including non-OPEC nations like Russia -- to cut production. This was a major shift for the cartel, which supplies about one-third of global oil production, after years of holding steady and even increasing output to maintain market share.
This unexpected move sent oil prices up sharply, and they've generally stayed higher since:
The other side of the coin is that the resurgence of crude prices has made a lot more North American oil cost-effective to produce, and American producers are taking advantage of the opportunity to ramp up output while prices are high. This is one reason oil prices haven't surged even higher this year.
The downside here is that it could realistically cause OPEC's low-cost producers to change course again. After all, historically, OPEC member's have a track record of not honoring their production commitments, and it's not a stretch to see a country like Iran continuing to increase its oil production, despite OPEC's "plans."
Could this potentially break OPEC apart? Possibly, but probably not. But it could do something just as bad: kill the agreed-upon production cuts, which, when factoring in the non-OPEC producers, includes nearly 40% of global oil production. If that were to happen, crude prices would almost certainly fall again as national producers battle for share to the detriment of non-nationalized oil companies.