Crashing oil prices have captured much of the financial markets' attention over the last eight months. In that time, prices fell nearly 60% to around US$48 a barrel in what felt like a never-ending spiral. Then in the space of just one week, the price exploded 20% which is a common definition for a 'bull market'.
Indeed, investors and analysts have desperately tried to predict the floor of the crisis. While some suggested it would bottom out at US$40 a barrel, others predicted it could drop as low as US$25 before prices one again began to rise. However, its most recent bounce , has sparked an enormous level of confidence that the floor may have already been found.
With Brent oil now changing hands for roughly US$57 a barrel (it rose more than 5% overnight), it's worth looking at the bull and bear case for the commodity, and for the energy sector as a whole.
Bull Case
The most recent spike in price has come as a result of the closure of 93 US oil rigs, according to industry analysts Baker Hughes, leaving just 1,223 remaining, down from more than 1,600 a few months ago. Several hundred more rigs are expected to be closed over the coming months too with many becoming economically unfeasible.
While this should not be taken as a definitive argument to suggest oil prices will rise (more on that below), it's certainly a sign that conditions in the market could begin to improve. In fact, as reported by Reuters, OPEC's (Organisation of Petroleum Exporting Countries) Secretary-General Abdulla al-Badri recently suggested that oil prices have already found a bottom, and that he sees a possibility of a jump as high as US$200 a barrel.
Although that is quite an outlandish figure, we do have to consider it as a possibility given that it was OPEC's own Secretary-General making the call. That's not necessarily an indication that OPEC will consider reducing its rather lofty production target (currently 30 million barrels per day), either. Instead, he believes that the higher prices will come as a result of lower investment in the sector. That is, lower spending on investments would lead to lower production which will help reverse the market's oversupply issue.
Higher prices would be fantastic news for energy producers which have seen their stocks hammered over the course of the glut. Should prices rise as high as the Secretary-General is suggesting, we could see unprecedented gains for companies like Woodside Petroleum Limited (ASX: WPL) and Santos Ltd (ASX: STO), which are two of Australia's biggest players in the industry, as well as smaller players like Senex Energy Ltd (ASX: SXY).
Before we consider the 'Bear' case for the industry however, it's worth noting that prices that high would actually turn an oversupply issue into an undersupply situation, which could be just as bad (if not worse). While high oil prices will obviously lead to high petrol prices for consumers, they are also associated with slower global economic growth. As such, a healthy balance needs to be found between supply and demand – a high price and a low price.
Bear Case
Obviously, these lower prices are squeezing the cash flows of the energy producers themselves, making them more reluctant to invest in new projects. Indeed, billions of dollars worth of Australian projects are at risk of being scrapped if prices don't recover further above their current levels. Even low-cost producer BHP Billiton Limited (ASX: BHP) recently stated that it would close 10 of its oil rigs operating in the United States whilst also slashing its exploration budget by 20%.
While rigs are being closed down in order to save on costs; investors need to remember that the relationship between rig count and production can be deceiving. After all, oil producers will be closing their high-cost mines but increasing their focus on their more productive rigs which are capable of producing even more.
Recent data from the US Energy Information Administration, for instance, showed that the nation's stockpile grew to more than 413 million barrels (its largest level since record-keeping began in 1982), which caused the price of West Texas Intermediate (WTI) crude to plunge more than 9% overnight on Wednesday.
The fact is, no producing nation is prepared to give up its own market share. While high-cost US rigs will continue to close, producers will continue to force costs lower in order to maintain the nation's energy independence. Meanwhile, OPEC-producing nations also rely heavily on the sale of oil to drive their economies, so they don't want to back off from their supply levels either. These are just a few things investors need to keep in mind.
The verdict
Given Abdulla al-Badri's position as OPEC's Secretary-General, his comments carry a lot of weight. While investment into the industry could slow in response to depressed prices; it's difficult to see the United States backing down from its own production targets or underinvesting in the sector's development.
That said, there really is no way of knowing what will happen next. By next week, prices could have retreated back to US$48 a barrel, or they could have climbed another 20% to US$70 a barrel. Regardless of what happens, investors need to remain extremely cautious when considering an investment into the sector and may want to remain on the sidelines until the high level of volatility subsides.
