Why Oil Prices Will Hit $500

Editor's note: When it comes to the oil industry, no one has more experience in the Texas oil patch than our friend and wildcatter Cactus Schroeder and our brand-new, in-house resource guru Flavious Smith.

Today's Masters Series essay is adapted and edited for clarity from the third episode of Porter's Stansberry Investor Hour radio show.

In it, Porter, Cactus, and Flavious discuss where oil prices are headed from here... what oil companies are doing to prepare... and how these "supercycles" work...

Why Oil Prices Will Hit $500
An interview with Porter Stansberry, Cactus Schroeder, and Flavious Smith

Porter Stansberry: Most of the time I've known Cactus, I have been fairly bearish on oil – especially since the mid-2000s. Since about 2006, I really got bearish.

What I saw happening, of course, was the things that everyone sees: There was a technological revolution happening with the combination of fracking, horizontal drilling, and using these things called proppants (like ceramic and sand) to increase the productivity of our drilling.

And Cactus was actually involved in these things. He's been a great source for me and helped me learn how things are happening. And it was Cactus who called me in 2010 and said, "Well, Porter, they 'ringfenced' me." And I'm like, "What are you talking about?" So Cactus, can you tell us how you got ringfenced one time in Texas?

Cactus Schroeder: Well, Porter, it kind of goes this way... We got down there before all the excitement started and we were drilling some Edwards Lime wells.

We knew we were in the good Eagle Ford area because we were getting really good shows... cutting through the Eagle Ford going down to the Edwards line. So consequently, we kept track of it... watching what other people were doing. We'd been down there probably two years and had accumulated close to 50,000 acres.

What eventually ended up happening was, once that first well or two got drilled in the Eagle Ford and everybody saw what a great play this thing was going to be, I got ringfenced. They started coming in and leasing everything around all my borders. And so we did have 50,000 acres, but they sure gobbled up all the acreage around us. And so we got what I call ringfenced.

That was the beginning of the Eagle Ford land rush. And it's just amazing what has happened down there since then. I saw a small town go from two restaurants and a convenience store to a town that had banks and car dealerships and Super Wal-Marts. It was just crazy the way that area down there developed through the years. And it's becoming active again. Not as much as the Permian, but it is still being quite active right now.

Porter: How has the development of the Permian progressed?

Cactus: It's progressed amazingly well. There's anywhere from two to seven pay zones in every well that they drill. So besides producing the zone that they're in, which might be a 5,000- to 10,000-foot lateral, they also have oil that they can book in that particular hole that's above them.

So it really looks good from the standpoint of engineering and reserves from a Wall Street standpoint and an SEC standpoint. Also, there's been a lot of folks selling out to big companies there that are basically turning it into a mining play more than a true oil play. They know it's there. It's just they're trying to get the cheapest and best way to get it out.

At this point, the Permian is by far the cheapest play in the United States as far as cost per barrel of oil. It's got the best infrastructure, the best pipelines, it's high-quality sweet oil. When you start looking at the other plays that are so much more expensive – whether that's Canadian oil sands, Bakken, or Gulf of Mexico – they're all substantially more cost per barrel to drill those types of plays. And so consequently that's one thing that's made the Permian so popular is that it's going to be there for several generations and it's also probably $35 or $40 oil.

Porter: Let's talk for a minute about price. One of the things that I've noticed that's very interesting is that further out in the futures markets, long-dated prices have fallen from around $85 per barrel to around $55 now – even going out several years. And it seems like the shale producers have used the recent OPEC cuts, which jawboned the price up to maybe even around $60 at one point, to hedge a tremendous amount of their production.

So the question I have for you is... when you talk to people in the oil business and you look at their hedging activities, would you say that the Texas production is rendering OPEC's power over the market price obsolete?

Cactus: Yes, I think there's a lot to be said about that. It's kind of disappointing to us smaller guys because the bigger oil companies have total staffs that take care of their hedging. And the first time they see those strip prices get up to a certain point, they're hedging out there. When they do that, it drives the price of oil back down.

So I think all the hedging going on has definitely had an effect on keeping the prices lower because every time they get up to a certain level, so many people hedge that it ends up driving the prices back down.

Porter: I have some data from Bloomberg that I don't know if you've seen yet, but I think it's very interesting. It says that a little more than half of the oil companies out there currently – I'm talking about continental producers, about 21 to 37 of them – have hedged any of their 2018 productions so far.

So almost half of them haven't hedged anything. And right now, in terms of total production that's expected for 2018, only about 10% has been hedged. What this tells me is if OPEC announces an extension of its cuts – or even if it announces a more aggressive version of its existing cuts – these producers are just waiting for the price to bounce up and then they're going to sell production like crazy.

That's why I think there's a big ceiling right now in how high the price of oil can go from here. Does that data match what you're hearing in the fields?

Cactus: There's definitely a ceiling there that I think has come down. They were hoping to get $75- to $80-per-barrel prices going into 2018. Now, it's probably more in the $60 to $70 range.

That's basically due to either they're waiting to get a better price or some of them have departments and they have criteria where they can only hedge 12 to 24 months. If they think it's better off to wait, they may have only hedged 12 months through 2017... waiting for 2018 to get better or to where they see a little bump. Once they see that bump, they'll go ahead and start their hedging.

I've never really talked directly with the people in the hedging departments of these larger companies, but I kind of watch what they do. You can see how they tend to follow one another. Also, the way the hedges are looking right now, we have a large number of companies that are hedging in the 2017 market and not as many as your stats are telling us.

But I think that might be because when we saw all the optimism last fall – when OPEC first made the announcement about its cuts – it really drove the prices up a bit. And people really capitalized and locked in their production for 2017 at that time.

Porter: Well, this is for the 2018 production. There were tremendous amounts of hedging from the 2017 production. Pioneer Natural Resources, for example, has hedged about 85% of their production this year.

So speaking in averages, I would say that the Permian producers have hedged more than half of their 2017 production. But they haven't yet stepped up to hedge 2018... as though they're expecting for some kind of a geopolitical event or perhaps an OPEC move to give them an opportunity to hedge to more than $60 per barrel.

Cactus: Well, yeah, Porter, but they also may have purchased a lot of production back there. There was a lot of activity going on with companies buying out other companies... and banks or financial institutions requiring them to allocate more hedging to the production that they were buying to make sure that they had a guaranteed price and that these institutions were going to get paid back in a timely manner.

So I think that might be part of it... as well as the actually waiting to see if there were going to be higher prices coming in 2018 due to any other OPEC or Russian activity.

Porter: That's right, yeah. I just want to make one correction to the data. If you look just at the Permian, the production there is about 22% hedged among the public companies. So 10% for continental overall and about 22% in the Permian. I think the increase in the hedging in the Permian is related exactly to what you said. It's related to the amount of financial acquisitions that have occurred there in the past six months. And those deals have to be hedged to get financing.

We have a new analyst working with us here at Stansberry Research, Cactus. His name is Flavious Smith. I don't think you guys have met each other yet. But Flavious actually is a veteran of EOG. He's got about 30 years in the corporate side of public oil and gas companies. He also built a small oil and gas company, a family owned one, for maybe a decade. He'll tell us the details about that in a second.

I just wanted to get you guys together to talk about this long-term idea. Because, Cactus, as long as you've known me, you've heard me saying that oil was going to go back below $40 per barrel. And happily, it happened twice. It happened in 2009 and it happened again in 2016, I believe.

I think that oil is going to go back below $30 per barrel in the second wave of this technological revolution we're in. And I think this lower price for oil is going to last for longer than most people expect. So we might see very low oil prices for another two or three years.

But Cactus, I believe that markets eventually work... and that the cure for low prices is – ironically enough – low prices. Cactus, can you believe that the amount of days production we have in storage in the U.S. has been above 30 for like 18 months? I mean, we haven't seen this kind of oil in storage in America since... ever.

So there's a lot of oil around and people are continuing to find more ways of producing it at a lower price. All those things eventually are going to cause a lot of oil companies some financial problems like T. Boone Pickens experienced in the mid-90s.

That will reduce investment. That will reduce discovery. That will eventually reduce production. And of course, you're setting yourself up for the next supercycle. I can't tell you when, but I can tell you that the coming supercycle – the coming leg up in oil prices – is going to be the biggest one yet. By the way, I don't think that's a risky prediction at all. This is the way the oil business works. It's not going to change.

But what is changing this time is the amount of people and the size of the markets that the U.S. oil business will soon be serving. When you look at China, India, and Indonesia – the billions of people around the world that are not consuming any oil currently that desperately want to have things like automobiles and air conditioning – there is an enormous demand... an insatiable demand for energy. There always will be. These lower prices are going to lead more and more people to experience energy in their lives. And they're not going to want to give it up.

So I can't say when – seven years, 12 years, 15 years – but we see oil bouncing back to over $500 per barrel. And we get that price by looking at the previous boom and bust cycles and just sort of taking the average.

Cactus or Flavious, you're going to have to help me with the prices, but if you know that the price of oil bottomed in 1998 at around $7 per barrel, expecting it to go tenfold to $70 might have been a bold prediction. But it wasn't. It actually went all the way to $150, which is more like twentyfold. I think you're going to see an even higher bounce back.

I just want to talk about the long-term trends in oil for a minute. Flavious, can you help us with some of these cycles and the price points? The one that I recall – I remember living through it – was the collapse in 1998. Does anybody remember how far oil fell in 1985?

Flavious Smith: I think it was $32 per barrel and it went to $10.

Porter: Ten dollars a barrel. And in 1998, it went all the way down to $7. Because you had the emerging markets' demand collapse at the same time you had a glut. And then, of course, it peaked at $150.

So if we think of $150 being the most recent peak, a tenfold increase from $150 would be $1,500 a barrel. I don't think that's even on anybody's radar, but that's kind of how these oil cycles work. Each peak is about 10 times bigger than the next.

Flavious: Right.

Porter: So if we see a bottom in oil of around $25 or $35, at some point, that would set up good for any investor who is interested in making a long-term commitment to the oil business. Flavious, what was your career like through these cycles?

Flavious: Like everybody else in the oil business, looking for a job sometimes and then having a job sometimes. But in 1985 and 1986, you couldn't find a job. In 1981, things were booming and then you couldn't find anything to do.

So you had to start your own business like I did. I drilled my first well in Nebraska... an old Denver-Julesburg well in Nebraska. I was on the rig and it came on. We did a dual stem test and oil came to the surface.

I called my wife and said, "We're rich."

I wasn't rich. But I felt like I was rich because there was oil everywhere and all over my clothes. It was fun. That old well's still producing, too. It's making about five barrels a day, so I'm still getting a little money off that deal.

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