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Why the Outlook for Oil Remains Pessimistic

It appears that bottom crude is in and the only way for energy stocks is up. Even the ever-pessimistic folks at investment bank Goldman Sachs have turned bullish, stating that the global supply surplus has come to an end. This is a sudden turnaround for Goldman, a bank well known for its bearish outlook on commodities.

Nonetheless, there are signs that the recent optimism surrounding crude is overblown and oil prices could decline once again.

Now what?

You see, despite declining output from places as far flung as Nigeria, China, and the U.S., bloated crude storage and growing OPEC oil production is threatening the longevity of the current rally. U.S. oil inventories are hovering around record highs, and in April 2016, OPEC pumped the most crude it has produced since 2008.

Then there are concerns that low-cost oil producers will continue to boost oil output as they seek to cash in on the recovery in crude. This not only includes countries such as Russia, Saudi Arabia, and Kuwait, which have all noted production increases, but also a number of oil companies.

It is easy to see that the oil crunch has forced companies to savagely cut costs and improve efficiencies in order to survive the current operating environment. Many are now operating with cash costs of less than US$15 per barrel, which means that as the price of oil climbs, there is a greater incentive to boost production and grow cash flows.

You only need to look at the largest landholder in the Bakken, Continental Resources Inc. (NYSE:CLR), which has been able to aggressively reduce costs to the point where it can remain cash flow positive even with crude at US$40 per barrel. Despite slashing its capital expenditures and subsequently reducing exploration and drilling activity, Continental expects 2016 production to remain unchanged from 2015.

Even deeply troubled Canadian oil producer Penn West Petroleum Ltd. was able to slash its cash costs to under US$14 per barrel for the first quarter 2016. Then you have Whitecap Resources Inc. (TSX:WCP), which continues to operate with low cash costs that were under US$15 per barrel for the first quarter because of its high-quality assets and tight control of costs.

The majority of North American light tight oil producers also have the ability to quickly ramp up production, and this, along with their low cash costs, means that as prices rise, there is considerable incentive for them to boost their oil output in order to grow cash flow. With near-record oil inventories, these factors will continue to apply pressure to oil prices.

In fact, despite recent optimism, Goldman expects the global oil market to return to surplus in 2017 as producers ramp up output in order cash in on higher prices.

So what?

The recent rally in crude has given considerable hope to a beleaguered North American energy patch and investors alike, but it appears to be increasingly premature to believe that higher prices are on their way. It will take some time for global oil inventories to fall and the rebalancing of demand and supply to reach equilibrium. As a result, investors should exercise caution when investing in energy stocks.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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