MARKET WATCH

Opinion: Why crude oil will average $80 a barrel in 2015


By Henry To / Published: Dec 2, 2014 8:32 a.m. ET


There are three arguments for this contrarian view


British banker and politician Nathan Rothschild once said: “Buy when there’s blood running in
the streets.”


And blood is certainly spilling in the streets of the oil and gas industry. The North Sea
benchmark, Brent crude, closed at $70 a barrel on Friday, declining by 40% since June. On
Tuesday it’s trading at around $72.


Energy stocks around the world lost $500 billion of market value in the past week, while many
oil-exporting countries will face budget crunches in 2015. Saudi Arabia needs Brent at $93 a
barrel to balance its budget; for Russia, as high as $120 a barrel.


We have argued for lower oil prices since last year, due to these three factors: 1. The
unprecedented increase in U.S. oil production due to more efficient horizontal drilling and
hydraulic fracturing technologies; 2. Weak demand growth in developed countries; 3. The
imminent slowdown of the Chinese economy, which has accounted for a third of the world’s oil
demand growth in recent years.


Gasoline prices will decline further, encouraging car travel and higher-than-expected U.S. crudeoil
demand in 2015.


Some analysts are calling for even lower oil prices, but we believe oil’s recent decline is
overblown. We believe oil prices are now close to a bottom, and that Brent crude will average
$80 a barrel in 2015, for the following three reasons:


1. Global oil production will decline in 2015, with Brent below $70 a barrel

Despite the recent decline in oil prices, the Energy Information Administration (EIA) still
projects global oil production will grow by 1 million barrels a day in 2015. U.S. oil production is
projected to grow by 1.1 million barrels a day, while Brazilian and Canadian production together
will grow by 200,000 barrels a day, with North Sea and Saudi production declining by 300,000
barrels a day.


Most other analysts, such as those from Goldman Sachs GS, -1.04% are projecting similar
production growth for 2015. Those projections made sense when Brent crude traded at $85-$90 a
barrel a month ago. With Brent crude closing at around $70 a barrel, those projections are now
outdated.


First, drilling for shale oil is very capital-intensive. Capital expenditures for U.S. shale oil and
gas firms soared to $80 billion in 2013. More importantly, the industry experienced a $9 billion
cash shortfall in 2013, after a $32 billion cash shortfall in 2012. That is, U.S. shale-oil producers
have never been cash-flow positive and had to borrow the difference to fund their growth plans.
With the recent decline in oil prices, shale oil producers will struggle to find fresh lenders willing
to underwrite their growth plans. Because shale producers need to constantly drill new wells to
maintain production, U.S. shale production will immediately decline if U.S. shale firms revise
their growth plans. The EIA estimates that U.S. shale production will decline by 300,000 barrels
a day in just 30 days if U.S. shale firms stopped drilling.


Second, most major U.S. shale-oil fields will lose money with Brent at $70 a barrel — after
factoring in the recent 2% to 3% rise in debt-financing costs for new fields — unless they slash
production by halting their drilling plans. Given the rapid depletion rates in “legacy” shale-oil
fields, we believe that U.S. oil production will decline in 2015 if Brent stays below $70 a barrel,
thus putting a floor on oil prices in 2015.


2. U.S. oil demand will surprise on the upside in 2015, with Brent below $70 a barrel


The EIA currently estimates U.S. gasoline consumption will decline by 20,000 barrels a day next
year, due to improving fuel economy and anemic highway-travel growth. This assumption may
be right when Brent crude traded at $85 to $90 a barrel, but not with gasoline prices now at their
lowest levels since 2009. In fact, AAA estimates that automobile travel over the Thanksgiving
weekend (November 26-30), was up 4.3% from last year, with 41.3 million Americans traveling
more than 50 miles from home by car. This amount of Thanksgiving driving is the highest in
seven years, and the third-highest since AAA began tracking Thanksgiving travel in 2000. If
Brent stays below $70 a barrel, U.S. gasoline prices will decline even further, thus encouraging
more automobile travel and higher-than-expected U.S. crude-oil demand in 2015.


3. The ECB’s 1 trillion euro quantitative-easing policy will support oil prices
The ECB’s vice president and second-in-command, Vitor Constancio, is now on record for
advocating a 1 trillion euro quantitative-easing policy to begin as early as the first quarter of
2015. With the eurozone’s inflation rate now at a five-year low (and expected to fall to zero due
to the recent decline in oil prices), we believe the argument for a quantitative-easing policy in the
eurozone is compelling. We expect the ECB to purchase 1 trillion euros of the eurozone’s
sovereign bonds (including those of Greece) over the next two years, to begin after its Jan. 22,
2015, meeting. This would improve the health of European banks’ balance sheets, which would
encourage lending and improve the region’s economic and inflation outlook. An improved
outlook in the eurozone will boost crude-oil demand and prices as well.


We are thus bullish on crude oil in 2015, and expect Brent crude oil to average $80 a barrel in
2015. Investors who want to go long on oil could consider the following ETFs: United States
Brent Oil BNO, +0.31% which tracks the spot price of Brent crude oil, and Energy Select Sector
SPDR XLE, +0.00% which tracks the performance of all energy stocks in the S&P 500 Index.


Disclosure: Neither the writer nor his firm, CB Capital Partners, holds shares in BNO or XLE.


Henry To, CFA, is partner and chief investment officer at CB Capital Partners. Established in
2001, CB Capital Partners is a global financial advisory and investment firm headquartered in
Newport Beach, Calif., with an office in Shanghai and an affiliate office in Mumbai.


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