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Tipsheet

Oil Market Perspectives

Below you will find a report on the oil patch from my friends at Lucia Capital Management. I am not an affiliated person with Lucia Capital Management or Lucia Securities LLC.

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You can watch me daily on their show Bucket Strategy Investing, which helps you put your money into short, medium and long-term buckets to help you get from here through retirement.

After falling 60% from a peak of $108 per barrel in mid-June, the price of U.S. crude oil (West Texas Intermediate) reached a low of $44 per barrel and has been range bound between roughly $45 and $55 during the past few months. Oil companies, investors, and even members of the Organization of Petroleum Exporting Countries (OPEC) appear to be scrambling to determine whether this is an inflection point or just a stop on the way to the bottom. While we cannot predict the future, we are taking this opportunity to put the current situation in context and provide our perspective.

The two charts below tell a great deal about the current oil price environment. Production in the U.S. peaked at an annual average rate of 9.6 million barrels of oil per day in 1970 and had declined to 5.0 million barrels per day in 2008, just as the “shale revolution” was gaining traction. Through the application of horizontal drilling and fracture stimulation technology, new supplies of oil were accessed from unconventional reservoirs such as shale. As a result, the trend was reversed, and U.S. production increased at a significant pace during the past five years, surpassing 9.2 million barrels of oil per day in early 2015.

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The rapid growth in U.S. production outpaced global demand growth, causing a supply surplus of approximately 1.5 million barrels of oil per day by the end of 2014.1 While OPEC had historically balanced the market by increasing and decreasing supply to align with global demand, this time it decided not to act, and oil prices collapsed as a result. OPEC’s rationale, dictated by its leading producer, Saudi Arabia, appeared to be that cutting its production would only lead to further increases in U.S. supply and thus decrease the organization’s market share and profits.

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We believe that the oil market will balance at a price that justifies enough investment in new supply to meet global demand. Given the low cost of production for OPEC and other large suppliers, such as Russia, we believe the price of oil in the near term will default to the marginal cost of the U.S. shale oil supply. In other words, the market will likely stabilize at the price that attracts enough U.S. shale oil investment to balance the market. While this concept is simple on the surface, there are a number of driving forces that make it difficult to predict oil prices.

In contrast to conventional oil production, horizontal shale wells are typically characterized by very high decline rates of approximately 75% during the first year of production. Thus, on the surface it would appear that the current supply glut could be resolved by a slowdown in drilling activity. The current surplus of approximately 1.5 million barrels of oil per day is relatively small compared to aggregate global production of 93 million barrels per day1.

Already we have seen a sharp drop in the number of rigs drilling oil wells in the U.S. The latest data from Baker Hughes, Inc. showed a decline of approximately 40% from the peak in October 2014, going from 1,609 to 986 deployed oil rigs, and the current oil rig count is the lowest it has been since 2011. However, the efficiency of the remaining active rigs is anticipated to increase as the rig count drops, resulting from an increase in the ratio of horizontal to vertical wells and a focus on only the most profitable opportunities.

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A growing backlog of drilled but uncompleted wells adds to this complexity, as producers are increasingly delaying completions in hopes of higher oil prices and/or lower completion costs. At the end of 2014, there was a backlog of 750 uncompleted wells in North Dakota’s prolific Bakken Shale play.1 As such, operators in this play could cease drilling for months and continue to increase production by completing new wells that are on standby. Additionally, operators are increasingly devoting capital to re-fracking and squeezing more production out of existing wells as opposed to drilling new wells, a trend that is not captured by the rig count data since drilling rigs are not required to fracture stimulate wells.

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As shown in the chart above, oil prices are volatile, and significant downturns are frequently met with upswings. Despite the improvements in efficiency and the expected decline in service costs, we do not believe this time to be any different. We believe that low prices may be the cure for low prices, as large oil companies have cut tens of billions of dollars from their capital budgets in recent months, threatening future supply as a result. Despite our expectation for a turnaround, we anticipate significant volatility for an extended period of time and would not be surprised to see oil prices drop further in the next few months as a result of continued oversupply and inadequate storage capacity.

Source: (1) Bloomberg

This material should not be considered an offer to buy or sell any security or the provision of specific investment advice. Opinions expressed here are those of Lucia Capital Management as of March 3, 2015; are subject to change; and may or may not come to pass. Past performance is no guarantee of future results.

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Lucia Capital Group
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(800) 644-1150 |www.luciacap.com

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There is no guarantee that any investment strategy will meet its stated objective. All investments involve risk, including potential loss of principal.

Lucia Capital Management is an SEC Registered Investment Advisor and affiliate of Lucia Capital Group. Registration as an investment advisor does not imply a certain level of skill or training.

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