The U.S. Government Just Poured More Cold Water on the Oil Market Recovery

The oil market hasn't recovered as much as most expected this year. One group that initially anticipated a slightly better market was the U.S. Energy Information Administration (EIA), which is the government agency in charge of collecting, analyzing, and disseminating information to help policymakers, the market, and the public understand what's going on in the industry. However, the EIA recently watered down its oil market outlook for 2017 and 2018, which suggests that it doesn't anticipate a recovery anytime soon.

Drilling down into the latest forecast

In one regard, the EIA was mildly bearish on crude prices heading into 2017, especially compared to some Wall Street analysts. Overall, the government agency expected that the U.S. oil benchmark, West Texas Intermediate (WTI), would average $50.66 per barrel this year, while the global benchmark, Brent, would be about $1 per barrel higher. That forecast was a few dollars below the prevailing prices at the time.

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However, even that outlook has turned out to be a bit too optimistic, which led the EIA to pare it back more than once this year. Its most recent view is that WTI will average $48.83 per barrel in 2017 -- which is 0.1% below its last prediction -- while Brent would be $51.07 this year, or about 0.7% less than its last guess.

Meanwhile, the organization doesn't see crude doing much next year. Its current view is that WTI will average $49.58 while Brent will be around $51.58. That tepid outlook on crude prices is coming despite the EIA's expectation that production in the country will come in below its previous forecast. For 2017, it sees oil output averaging 9.25 million barrels per day, which is 1% less than its last outlook. Furthermore, while it anticipates that U.S. production will increase to an average of 9.84 million barrels per day next year -- marking the highest average annual level in the country's history -- that's 0.7% below its prior view.

In the EIA's estimation, even though production in the country won't be as high as it anticipated, that alone won't be enough to drive oil prices higher. That's because it expects other factors to offset those lower supplies, including persistently elevated oil stockpiles and larger oil supplies from OPEC and elsewhere that would mostly match demand.

How could this impact oil stocks?

This forecast is a downer for investors in oil stocks that need higher crude prices to fuel growth next year. For example, Permian Basin-focused Pioneer Natural Resources' (PXD +0.00%) 2018 growth plan requires $55 oil to enable the company to increase output 15% while living within cash flow. Meanwhile, Devon Energy's (DVN +0.01%) current plan for next year is to deliver 20% higher U.S. oil production. That said, Devon needs crude to average $60 a barrel to achieve that growth rate within cash flow. Because many U.S. producers need higher oil prices to fuel their current growth plans, they have a choice: Either use their balance sheets to bridge the projected gap between cash flow and capital needs, or reduce their growth rate. Those with stronger financial profiles like Pioneer and Devon might opt for the former option while they continue to push out costs as they wait for higher prices. Meanwhile, producers with weaker balance sheets will likely have no choice but to pare back growth-focused spending.

That said, for the lowest-cost drillers, the EIA's forecast revision isn't much of a concern. Two of such oil stocks are EOG Resources (EOG +0.01%) and Encana (ECA +0.01%) since they've already set $50 crude as the baseline for their go-forward plans. In EOG's case, it can deliver 15% compound annual oil growth through 2020 and pay its current dividend while living within cash flow at $50 crude. Meanwhile, Encana is on pace to deliver the objectives of its five-year growth plan to boost production 60% by 2021. While Encana initially needed $55 oil to fuel that forecast, thanks to its rapidly improving operations, it can now achieve it with $50 crude. 

The low-cost leaders are the way to go

The latest outlook from the EIA seems to suggest that the oil market is spinning in circles, as it doesn't anticipate that lower-than-expected output will provide any spark for oil prices. That's bad news for producers that need higher prices to thrive. Investors should focus their attention on ultra-low-cost producers like EOG and Encana, because these companies can flourish at $50 oil, which could enable them to outperform their rivals if the EIA's forecast pans out.