After enduring back-to-back annual losses, energy investors are wondering if the market will turn the corner in 2016. Excessive crude oil supply began to manifest in early 2014. OPEC’s November 2014 decision to defend market share — which I discussed in a recent appearance on CNBC Asia’s Squawk Box — hit the energy sector hard in 2015. Those negatives continue to hang over the oil markets in 2016.

While shale oil production started to decline last year, it didn’t do so as quickly as OPEC expected. Nevertheless, prior to OPEC’s 2014 meeting there were 1,600 rigs drilling for oil in North America, and today there are 516.  

Global demand also continues to rise. Last year the International Energy Agency (IEA) reported that oil demand was growing at the fastest rate in five years. How will we know when the market begins to turn the corner? Look to global inventories.

One good source of this information is the Energy Information Administration’s (EIA) monthly Short Term Energy Outlook (STEO). This report contains numerous projections on global oil supply, demand, and inventory levels. Currently the EIA’s projections show the inventory builds slowing dramatically this year in response to global production declines:

Note that the EIA is projecting that global production will reverse very recent declines and grow once again in 2016. But that’s because the agency is forecasting higher oil prices. EIA forecasts that Brent crude will average $56/bbl in 2016, and that WTI prices will average $51/bbl — about 70% higher than current prices. Note that if the EIA is wrong and production doesn’t begin to rise (which I think will be the case for at least the next six months), then global inventories should start to come down, eliminating one of the major downside risk factors for oil prices.

Until that happens, the potential for further declines remains. Oil could spend some time in the $20s, but the longer prices remain below an economical level, the harder they are likely to swing in the other direction. I expect inventories to peak and begin to decline around mid-year, and then oil prices should make a quick move back above $40/bbl.

There is no question that today’s oil price is unsustainable. The world’s oil supply will not meet global demand over the next few years at $30-35/bbl. Producers will need a higher price before they will invest sufficient capital to ensure that future demand is met. For now, drillers will try to hang in and survive until the market comes back into balance.

How should an investor play this uncertainty? Look to companies with strong balance sheets, and start to average into the market. Buying now while others are fearful should pay off eventually. But do average in to limit your downside risk, and be prepared to be patient. It is likely that a recovery is still at least months away.

Which companies are the safest bets? Join us at The Energy Strategist as we analyze the latest corporate data. We will highlight companies with strong balance sheets and stocks that have already priced in the worst-case scenario.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Shale Not Out of Bullets in Price War    

This isn’t news specific to a portfolio recommendation, but rather something relevant to most of them. The latest U.S. Energy Information Forecast issued on Jan. 12 predicts a 7.4% drop in U.S. crude production in 2016. Natural gas production, meanwhile, is expected to increase 0.7%.

Why isn’t domestic oil and gas production dropping faster despite the well known tendency of shale wells to suffer big production drop-offs after the first year? Mainly because the supply of capital available to the producers hasn’t really dried up, and the most efficient drillers haven’t stopped doing their thing.

Notably, Pioneer Natural Resources (NYSE: PXD) said last week it’s aiming to increase its output by 10-15% in 2016. Pioneer is benefiting from prolific Permian Basin wells its says are delivering a 30% internal rate of return at current prices, as well as the foresight to hedge the bulk of this year’s expected crude output at an effective price of more than $50 a barrel.

Production gains are also a big factor in the formula used to award management incentives. Shareholders have also incentivized growth, noted the CEO, telling The Wall Street Journal that “[competitors] that announced production declines into 2016, their stocks are getting hammered.”

In contrast, Pioneer’s stock is down just 17% over the last year despite last week’s $1.4 billion equity sale, which diluted prior shareholders by at least 8%. The money raised will cover a little over half of this year’s budgeted capital spending.

The availability of so much equity capital on relatively favorable terms is bad news for the endangered species of crude bulls but a welcome development for the midstream sector that  needs the U.S. oil and gas to keep flowing.

Besides the prospect of pipeline flows drying up, the other bogeyman for midstream investors has been the threat of distribution cuts necessitated by financing shortfalls for expansion projects. But two master limited partnerships this week locked down their 2016 fundraising without resorting to equity sales that no longer make economic sense given their double-digit yields.

Plains All American (NYSE: PAA) said it has satisfied its “equity financing needs for all of 2016 and, in all material respects, all of 2017” by means of a convertible preferred placement. The securities pay annual interest of 8% and can be converted into PAA units after two years at a 33% premium to the current price.

In a related development, PAA announced a quarterly distribution matching the prior quarter’s payout. The preferred issue largely takes off the table the risk of a cut to a distribution currently yielding 14%.

Meanwhile, Oneok Partners (NYSE: OKS) said this week it’s met all its 2016 funding needs with a $1 billion three-year unsecured floating-rate loan tied to its credit rating and the London Interbank Offered Rate. The current annual finance charge is a very reasonable 2.73%. This arrangement looks like a slam dunk versus the option of issuing more equity with a current yield of more than 12%.

So the decently capitalized large-cap drillers and the big pipeline owners don’t seem to be having much trouble attracting outside capital at the moment. But foreign oil exporters’ budget deficits continue to grow. Don’t count out shale in this price war just yet.     

— Igor Greenwald