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Oil Prices: Next Stop $85 a Barrel?

By Matthew DiLallo – Sep 30, 2017 at 10:47AM

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With crude recently entering a new bull market, analysts are turning decidedly bullish.

What a difference some new data makes. A few months ago, analysts were throwing in the towel on the oil market, with several slashing their price targets on crude and downgrading oil stocks. However, thanks to a string of bullish data, oil prices have quietly risen 20% from the most recent low, touching off a new bull market.

This reversal seems to be changing the mood of the oil market. Instead of focusing on the negatives that could pull crude lower, analysts are increasingly turning their attention to the catalysts that could fuel an even greater run. In fact, one recently made the case that crude might go as high as $80 to $85 a barrel. While a lot would have to go right for that to happen (or wrong, if you're a consumer), it's not as far-fetched as it might seem.

An offshore drilling rig at sunrise.

Image source: Getty Images.

Bringing balance back to the market

The primary catalyst fueling crude's recent run is that supplies are finally falling in line with demand. That's because of moderating production as a result of high levels of compliance among OPEC members with their output cuts, as well as some recent supply disruptions because of renewed turmoil in Libya. On top of that, demand growth from places like the U.S., Europe, and China has been unexpectedly robust and is running so hot that the International Energy Agency recently upwardly revised its full-year outlook again.

These factors are starting to deliver a "real rebalancing in the oil market," according to Jodie Gunzberg, who is the head of commodity and real asset indices at S&P Dow Jones Indices. In an interview with CNBC, Gunzberg stated that "the fundamentals are changing," and because of that, "the market is rebalancing." This notable shift could continue to push oil prices higher. In her view, "When we look at the index data, we can see the price could move even as high as $80 to $85 (a barrel)." While she doesn't see crude hitting those prices anytime soon, shortages in the marketplace could drive oil to that level since it takes the industry time to bring on new production and catch up.

From glut to squeeze in a matter of months

She's not alone in suggesting that crude could surge from here. Citigroup's Ed Morse, who is the bank's head of global commodity research, recently told Bloomberg that "there could be a supply gap emerging, which could point to a tighter market." He noted that the problem is with OPEC because several members are already pumping at max capacity and might not be able to boost output any further if there's a call for additional oil from the market. In Morse's view, this market squeeze could happen as early as next year.

These bullish views are in stark contrast to the pervasive bearishness across the analyst community earlier this year. In late June, for example, Seaport Global downgraded 51 energy-related stocks after changing its mind on oil prices. The research firm believed that the industry's trajectory would result in the market being oversupplied by as much as 2.2 million barrels per day next year, with the glut only getting worse through 2020. As such, it foresaw crude heading back into the $20s by early next year, estimating it would only average about $35 a barrel during the first half.

An oil field at sunset.

Image source: Getty Images.

What changed?

Aside from unexpectedly robust demand and high compliance by OPEC members, one factor that has turned around the market's opinion on where prices are heading is that shale producers exercised discipline and started tapping the brakes when crude dipped into the $40s. Pioneer Natural Resources (PXD 0.23%), for example, fell behind schedule last quarter because of some unexpected drilling delays. However, instead of reaccelerating in an attempt to catch up, the company decided to defer the completion of several wells until next year "in light of the current commodity price environment." Because of that, Pioneer Natural Resources expects production growth to be at the low end of its guidance range. Meanwhile, Whiting Petroleum (WLL) cut its budget last quarter to better match capital expenditures with cash flow. As a result, Whiting will drop two drilling rigs, which will only enable it to increase output 14% by the end of the year, rather than the 23% it initially anticipated. Because of these and other cuts, U.S. oil production growth won't be nearly as high next year as originally feared.

Meanwhile, other producers are choosing to return more cash to shareholders instead of spending it to boost production further. For example, oil giants ConocoPhillips (COP 1.11%) and Anadarko Petroleum (APC) announced multi-billion dollar stock repurchase programs. In both cases, these producers figured that they could increase their production by a faster rate on a per-share basis through a buyback than if they spent that cash on drilling more wells.

The recipe for a rapid rise in crude

The global oil market currently consumes about 96 million barrels per day. As long as the industry produces around that level, prices should remain relatively stable. That said, three factors could quickly knock things out of balance and cause prices to spike. First, demand needs to stay red-hot. Next, producers must remain disciplined, which means shale drillers can't quickly reaccelerate as soon as prices move higher, and OPEC needs to stick to its plan. If both of these factors occur, it will leave the market with less margin for error. That's when the third factor could come into play, which is a major unexpected supply outage that disrupts the fragile balance. Any of several potential supply shock scenarios could occur, such as the U.N. slapping new sanctions on Iran, a string of terrorist attacks on Middle Eastern oil hubs, or significant damage to production facilities from natural disasters. Add those three ingredients together, and it's conceivable that crude could quickly spike to the $80s.

That said, while such a scenario is certainly possible, it would be a risky gamble to start blindly pouring money into oil stocks in hopes of cashing in on what still appears to be a low probability outcome. Instead, investors should focus on low-cost producers like Pioneer, Conoco, and Anadarko, since they can thrive in the current environment, which means they'd still have ample upside if crude turns sharply higher. 

Matthew DiLallo owns shares of ConocoPhillips. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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