Five years ago, in the article that landed me a role writing for MarketWatch, I said that there was "one general thing that changes everything for America." That one thing was the advent of American shale oil. The "fracking" revolution in the United States quickly went on to help oil prices crash and reduce America's dependence on Middle Eastern oil by half. 

Today, we are on the cusp of massive interconnected changes in the oil industry. Three of these things all but guarantee that oil is headed back to $100 per barrel. The decline in oil production from existing wells, OPEC's control of low cost oil production and the revival of U.S. fracking growth will all drive oil prices higher.

Oil prices will not necessarily stop rising at $100 either. There are two more factors that could drive oil well past $100 that I will cover Friday. It all adds up to a golden opportunity to invest in certain parts of the oil complex one last time before electric vehicles and new methods of creating plastics take hold in the 2020s.

Oil Production Decline Rates & Lack of Development

While many would point to OPEC as the main driver of oil prices, they rank only as #2 on my list of most important factors to drive a rise in oil prices. Perched atop the list is the mundane "decline rate" of oil production by existing wells coupled with the lack of new "megaprojects" coming online. 

The decline rate is simply the reality that oil wells produce less oil over time. Depletion by contrast is the rate that oil reserves are reducing. Think of decline rate as micro to the well and depletion relating to total oil in the world.

The reason that the decline rate is so important right now is that there has been nearly a trillion dollars worth of megaproject development canceled the past three years through the early 2020s. Megaprojects are those that require near or more than a billion dollars to develop, such as deep water and oil sands developments.

The cancellations in deep water and oil sands have happened for two overwhelming reasons. The first reason, was a short-term reaction to the OPEC decision to supply more oil to the markets which led to the price collapse from 2014-2016. While fracking got most of the attention in the U.S., the impact of low oil prices on megaprojects was much more impactful in the long run.

The second reason for fewer megaproject developments is the long-term fear that soon, the oil industry will wake up to this press release: "Our electric cars are now able to go 400-600 miles on a charge, cost the same or a little less than gasoline powered cars and there is far less maintenance costs associated with our EVs than gasoline powered cars." 

I'm not sure which auto company will make that announcement, althought the short list is Tesla (TSLA), pretty much by themselves. There are also several dark horses including Toyota (TM) and BMW. Be very clear about this, that announcement on EVs is a question of "if," not "when." Once it occurs, the demand for oil will turn from slow positive growth to accelerating demand destruction as half of all oil is used in cars.

Taken together, the impact of OPEC and the imminent advent of electric cars, when combined with the large up front capital commitments and long payback periods of deep water and oil sands make those projects too risky to finance in most cases. As a result, investors should not expect there to be a flood of new oil supply to hit markets ever again from deep water or oil sands ever again.

Companies are outright avoiding developing megaprojects because they are aware of what is coming in electric vehicles. The oil majors know we are at the beginning of the end of the oil age (I got mega-trolled for that article) and are adjusting. Conoco Phillips (COP) last year cancelled all deep water exploration. Exxon (XOM) has been changing their asset portfolio and just acquired a major stake in the economic Permian Basin which is loaded with lower-cost, short-cycle projects. Expect those transitions to continue across the industry with much of the deep water leases expiring or never being developed.

About 30% of global oil is from the deep water. The decline rate for deep water oil is highly variable, but ranges from 5% to 15% per well. Because of the massive slowdown in new megaprojects, different sources of oil will be used instead. In the short run, that creates a problem as deep water oil supply flattens and then contracts.

The shortage of megaproject development has led Deloitte to estimate, considering annual decline rates globally of all oil of just under 3%, that currently committed capital development for new oil production is about $2 trilion dollars short of being able to replace the oil that producers are producing today. Various estimates suggest that lack of develpment could leave the world a whopping 10-20 million barrels per day short on supply within a few years. 

This problem is hidden in plain site and many investors are missing it. Schlumberger chairman and CEO Paal Kibsgaard said during a conference call with investors. "The main challenge is going to be to reverse the effects of several years of global (exploration and production) under-investment and then mitigate the impending supply shortage we see unfolding."

Even with some new development in the U.S. shale plays, international oil development investment is set to fall in 2017, not rise as needed. American-centric investors often fail to realize that U.S. shale only produces about 5% of the world's oil. So, increases in that production are unlikely to add more than a few million barrels per day over a the next few years. 

OPEC & Russia Production Cut

The recent cut in oil production by OPEC and Russia is what is grabbing headlines today, however, it is a distant second to the unreplaced decline rates discussed above. Pundits and traders focus on whether or not OPEC and Russia will indeed make the negotiated cuts rather than see the bigger picture. It is a classic case of not seeing the forest for the trees. 

The forest in this case is the implied threat that OPEC holds over the oil global oil industry. That threat is, of course, that they will tap more oil if higher priced competition ramps up. This is yet another massive deterrent to the oil majors heading into yet more megaproject development. 

When the previous Saudi oil minister Naimi visited Houston a year ago he made it very clear to the oil industry not to produce higher cost oil because OPEC would just undercut them. Saudi Arabia has about 2-3 million barrels of easy to access oil capacity they can turn to and another 5-10mbd that they can add with some lead time. Expect them to at least tap the 2-3 mbd as oil demand continues to drift upward in the short run and megaprojects continue to be scarce. 

While the focus by traders on short-term compliance for the oil cuts had some value on a day to day basis, the intermediate term reality was it didn't matter much. As it turns out, the cuts are proceeding along nicely.  As of the past week, 1.5mbd of oil have been cut back of the 1.8mbd goal. It appears that participants to the cut agreement will be up to 1.7mbd of cuts by next month. 

The next argument for cheaper oil, that traders will make, is that the cuts won't be renewed in June when scheduled to expire. Here's the thing, the cuts don't probably don't need to be renewed. The decline rates are that significant. 

The timing of the OPEC cuts expiring jive very well with the decline rates and the American summer driving season. As Americans head to their cars to drive the country, oil demand will rise and OPEC will be there to supply that oil. While a few hundred thousand barrels of shale oil will be flowing by then, that's barely (or maybe not) enough to offset America's overall declines from conventional wells. 

As we can see in this EIA chart from the recent Short-term Energy Outlook, the oil market is near balance right now.

Oil Demand and Supply (EIA)

 

It also shouldn't be lost on anybody that the OPEC nations and Russia do not want to leave their oil stranded in the ground. Anybody who expects the oil majors to ramp up production via megaprojects just has no clue what they are talking about. OPEC is still the global swing producer and is a clear winner going forward. OPEC in the short run, which might be all that's left for oil, will increase its market share because of all the cancelled development they caused with their oil price war.

Trump's Drive to Profit from Oil

In a "slow growth forever" world, there are fewer ways to generate huge wealth anymore. That is not an indictment of anybody, it is just economic reality laregly based on overwhelming aging demographics.

Oil is still one of the ways to generate great wealth - at least until we wake up to those better and cheaper electric cars. The Trump administration, like OPEC and Russia, want to get as much profit from their nation's oil resources as possible. 

For the U.S. there are three core motivations to ramp up shale production again now that the oil decline rate is taking hold. First among the reasons for the U.S. to add shale production is to move towards energy independence from OPEC. That's not the same as energy independence. We are many years away from being energy independent, however, we could nearly eliminate our use of Middle Eastern oil in the next several years with added domestic production, a bit more from Canada, more from Mexico and more from other nations in the hemisphere. 

The second reason that oil production will ramp up under the Trump administration I already mentioned above. They do not want to leave our oil stranded in the ground. It's too valuable in their eyes. There is literally trillions of dollars to be made yet in oil if we decide to do it. It appears that decision has been made for at least the next several years.

[A big argument to leave oil stranded in the ground is climate change - which I find legitimate. I suspect that President Trump also understands that climate change is man made. He is willing however, to put off signficant climate change actions for a few years to help the economy. I don't mean to be flip about this to other tree huggers, but we'll see if technology and planting trees can fix what we break environmentally before the planet tries to flick us off. I sure hope so. And frankly, I'm optimistic so long as we pivot soon. More on that in future articles.]

Number three on the list is that expansion of domestic oil is good for domestic employment. By ramping up shale production and building America's last oil pipelines, the Trump administration can add a short-term stimulus to the economy. The unfortunate truth in America is that many have been left behind as the economy transitioned from old to new. Increasing oil production is seen as a bridge to the future.

Increased U.S. oil production should also relieve a little pressure on rising oil prices in the next few years, but not much. Once again I will point out though that increased shale oil production is not enough to hold oil prices down much. The decline rates for other oil are just too high to overcome.

Interestingly, increased shale production will probably keep costs for producers from falling any further. Why? Simply put, there is not enough services and equipment capacity to keep that trend in place. Oil services and equipment are due for a price rise due to the wipeout we just experienced in the space. We already know that Schlumberger (SLB) and other companie are raising rates for drilling and services. 

Ulimately, what is developing is a nirvana for domestic oil. Not only will prices and volumes rise for the exploration and production companies, but the prices received are rising for the services and equipment companies as well.

Big Losers in Oil

I have discussed this before and will bring it up again. Deep water oil is on its death bed. While existing projects will keep producing, new projects will be few and far between. I dove pretty deep into this topic on MarketWatch back in 2015 and want to reiterate the deep water oil is no place for investors. 

The costs associated with building deep water megaprojects are just too high and the paybacks too long. It's not only Conoco that cancled their exploration of deep water but other companies too. Even Exxon, as I mentioned above, is trying to turn their ship away from new deep water development. Don't fall for the hype to buy the deep water companies when oil does rise as I am saying.  

According to Wood Mackenzie, companies are set to spend less than $40 billion on deep water development in 2017. That is their lowest amount in eight years and far less than the $100 billion from just two years ago. This reality is going to continue to be terrible for deep water drilling companies. 

In the article linked above, I told people to get out of Seadrill (SDRL) and Transocean (RIG). Both have plummeted since then. If I owned those stocks, I would sell both RIG and SDRL. In fact, to the extent it is affordable, I think both stocks are still shorts. Seadrill, I believe will ultimately go to zero (my first and only zero call to date) and recapitalize as a maintenance company. The recent rally by Transocean is just that, a relief rally. I think RIG will head back to single digits eventually.

The exploration and production companies most exposed to deep water oil should also be avoided.  

Winners in Oil

By now it should be clear that OPEC is a big winner going forward in oil. Russia will signficantly benefit too in the short run. Both OPEC and Russia will need to hurry to diversify their economies though. I'm not sure either can pull that off. Investing in the OPEC nations or Russia is difficult and not for the faint of heart, although there are likely some great trades in those wild markets.

The biggest oil winners for invesors are those that are tied to the U.S. shale and some Canadian companies. 

Among my favorites are the equipment and services companies. Those companies are lean right now and heading into a rising price environment. Much like the companies that came out of the solar crash of 2011-12, many of the oil services and equipment survivors are set to make a lot of money for a while. Importantly, according to Ned Davis Research, the services and equipment companies are more levered to rising oil prices than the exploration and production companies.

My favorite ETF for services and exploration companies is the SPDR S&P OIl & Gas Equipment and Services ETF (XES). It is more evenly weighted so it gives more exposure to the midcap companies. I like that approach as some of the large caps are still reeling a bit. I have been accumulating XES and rate it a buy up to the middle $30s.

I am also a fan of the First Trust Natural Gas Stock ETF (FCG). Why a natural gas stock ETF? I'm glad you asked. The companies in the index are very levered to both oil and gas in the shale. I like the diversification of getting natural gas because that is where fossil fuels is going more and more. I am also very interested in being mostly in shale.

FCG's index is nearly even weighted and offers great exposure across the midcap companies which is attracive for all main reasons midcaps are attractive - less failure risk, still good growth and potential for buyouts included. This ETF is way off of its top and the index has greatly improved as many companies were wiped out. These are the survivors of the recent wipe out as well. I have been accumulating FCG for over a year and rate is a buy into the middle $30s as well.