The Energy Report: You've written a provocative research report titled "Hello, We'd Like to Report a Missing 200 Million Barrels of Crude." It argues that the global oil inventory should have grown by over 200 million barrels (200 MMbbl) during the first six months of 2012. Where did this oil go? And a better question is, why hasn't this surplus shown up in pricing?
Marshall Adkins: When the U.S., the European Union and the United Nations imposed sanctions against Iran, the world responded by putting oil into storage. China rapidly began filling its strategic petroleum reserves. Saudi Arabia topped off its surface reserves. Iran put oil in the floating tankers.
TER: Why isn't this storage being reported? Is it normal for this oil to not go into the regular reporting channels?
MA: Yes. Unfortunately, it takes three or four months, and often six months, to get good data from the Organization for Economic Cooperation and Development (OECD). It's a lag, but at least you usually get the data. We estimate that OECD data accounts for about two-thirds of global oil inventory capacity. The other third, which is just an estimate, is off the radar. Few sources really track this non-OECD data. The International Energy Agency (IEA) does not track it either, because there's simply no reliable way of getting the information. China is probably the best example of that. It just does not tell us exactly how much it has.
TER: Could this result in dumping at some time in the future, potentially after the November election in the U.S.?
MA: It could. But even if they don't dump it, we think there is an even bigger structural problem. We are running out of places to put the growing supply of oil. Based on our supply-demand numbers, the world is poised to build significant inventories in early 2013. There is a very real possibility that if Saudi Arabia does not initiate production cuts sometime in early 2013, we will run out of places to put this oil around the world.
TER: Your particular specialty area is oilfield services. You maintain a U.S. rig-count table, which showed a 6% drop year-to-date as of August 31, 2012. Does this indicate that it's getting easier to get oil horizontally than it is to drill straight down?
MA: There is no question that the application of horizontal oil technology has completely changed the game for both oil and natural gas here in the U.S. Yes, it's just a much more efficient way of extracting oil and gas, particularly from formations that are very tight. This is a trend that's going to be here for a long time. It has led to an incredible increase in production per well.
TER: I noted dry gas rigs in your table are down 57% during that same one-year period. Even wet gas rigs are down 40%. How long can this go on before gas prices turn around?
MA: The decline in the overall rig count this year is mainly a function of the falling natural gas rig count, both wet and dry gas rigs. Early on, oil rig growth offset a lot of that gas decline, but the growth rate in oil has stagnated. So, low prices for natural gas are causing a meaningful decrease in gas drilling, but we think there will continue to be reasonable growth in gas supply from the oil wells in operation. That said, gas prices should gradually rebound as we build out infrastructure and consumers start to take greater advantage of extremely low gas prices in the U.S. Next year, we think the overall U.S. rig count will continue to deteriorate with lower oil prices. As that happens, overall gas production growth should flatten. That allows growing gas demand to offset stagnating supply growth. That should eventually drive U.S. natural gas prices higher. It will take a while, but we expect gas prices to improve steadily over the next several years.
TER: Natural gas prices were up about 35–40% before summer. Was this just a bounce, or could this be the beginning of a bull market in natural gas?
MA: I wouldn't call it a bull market in gas. Gas prices have certainly improved, but I think most people who are out there drilling for gas would say that $3 per thousand cubic feet ($3/Mcf) isn't exactly a bull market. They simply aren't making a whole lot of money at that price. That said, today's prices are much better than six months ago and things are looking better. We think natural gas prices will average closer to $3.25/mcf next year and $4/Mcf the year after. Yes, we think the gas price bottom that we saw earlier this year, $2/Mcf, is well behind us. Directionally, things should continue to improve.
TER: Should investors be bullish on any segment in energy right now? If so, which ones?
MA: In light of our relatively bearish overall stance on crude, we don't have any Strong Buy recommendations in our oil services universe. We're not recommending a whole lot of exploration and production (E&P) names at this stage either. The ones that we think do perform here are refiners that benefit from the price differential between West Texas Intermediate (WTI) and Brent crude. In addition, infrastructure companies such as master limited partnerships (MLPs) and companies that service either pipelines, refineries or other new infrastructure should outperform over the next several years.
TER: Any final thoughts?
MA: The bottom line is that we have a tough six months ahead of us for crude oil prices as inventories continue to build in Q1/13. Sometime in early 2013, oil prices should deteriorate as much as 30% from where we are today and hit bottom in mid-2013. At that point, we'll probably get a lot more constructive on oil services and E&P names.
TER: Thank you very much.
MA: Thank you for having me.
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 15 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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