Hot Year in Store for Energy

I believe we will look back in a few years at 2016 as the year the energy sector recovery got underway in earnest. But I know many who disagree. I see plenty of analysts predicting that the recent OPEC agreement to cut production will fall apart, and then the bottom will fall out of the oil market. Or that the spike in natural gas prices will prove to be short-lived.

I disagree with both assessments. Below, I explain how I see the energy markets shaping up this year, in the context of my 2017 predictions.

1. Crude oil will flow through the Dakota Access Pipeline (DAPL) in 2017

Donald Trump’s surprise win in the 2016 presidential election will result in some big changes in U.S. energy policy. One immediate impact will be in the support at the highest levels of government for oil and gas pipelines. The Obama Administration implicitly encouraged opposition to high profile projects like the Keystone XL Pipeline, and more recently the Dakota Access Pipeline (DAPL). Decisions on these projects came down on the side of pipeline protesters.

With Trump in office, DAPL will be completed and oil will flow. The only real uncertainty in my mind over this prediction is that Trump comes into office pretty disorganized, and President Obama has put a lot of obstacles in front of him. He will have a lot of competing priorities, and there will be legal challenges. Nevertheless, I expect the pipeline to be completed and the oil to flow this year, which will provide a boost to Energy Transfer Partners (NYSE: ETP).

2. The price of WTI will average at least $15 per barrel higher than in 2016

I feel compelled to make an oil price prediction, but this year is much more difficult than a year ago, when I was confident that there would be a strong move upward from $30/bbl. In 2017 I think oil prices will continue to move up, but a lot of optimistic expectations are already factored into the price. 

According to data from the Energy Information Administration (EIA), the average closing price for West Texas Intermediate Crude (WTI) in 2016 was $43.31. During the year the price closed as low as $26.19 and as high as $54.01. The EIA’s most recent Short Term Energy Outlook projects Brent Crude prices to average $51.66 and WTI Crude prices to average $50.66 this year, but many are predicting a return to $40 or lower in 2017.

As I write this, WTI is trading at $50.81 and Brent is $53.62. This prediction will require the price of WTI to average at least $58.31 for the year, which is an average that is 15% above the current price, and also currently above the futures price of every contract trading in 2017. This prediction is essentially a bet that the OPEC production cuts will largely hold, which will minimize the risk of a strong downside move. However, there are headwinds to the upside. Even now the U.S. rig count is increasing, and while it is still only a third of the highs of 2014, it is up 60% since summer and will continue to rise alongside oil prices.

As a result, I think this will be a less volatile year for oil, with dampers on the high as well as low side. We should reach $60, and I think OPEC is targeting at least that level. But it is hard to convincingly argue that the annual average will go that high considering the current price, the fact that global crude inventories are still extremely high (though falling), and the expected increase in U.S. shale oil production.

This is a prediction that hinges on many factors, which makes it all the more difficult. If by the second quarter it is clear that global crude inventories are coming down rapidly, then I think we will see a $60 average for WTI for the year. However, if we see the OPEC agreement start to fall apart, we will likely retreat back to the $40s temporarily. So while some may not consider this an extremely aggressive prediction, it is a difficult forecast that could look silly in hindsight depending on how events play out.     

3. The average Henry Hub spot price for natural gas will be above $3.50/MMBtu

In 2016 the average spot price of Henry Hub natural gas was $2.52 per million British thermal units (MMBtu). But by year-end the price was surging in response to depleting inventories. At present the forward price curve for natural gas in 2017 ranges from about $3.20 per MMBtu up to about $3.40, before falling back below $3 in early 2018. This seems too low given the strong demand growth coming online from new petrochemical projects, the utility sector, liquefied natural gas exports and growing pipeline exports to Mexico. Demand has been growing for years, but production growth has kept pace, keeping prices depressed. Natural gas production stalled in 2016 in response to low prices, and although I think it will bounce back this year I think this year we see demand get the upper hand.

The weather always has a strong influence on gas prices, but unless there is an extended bout of mild weather it will be hard to keep natural gas prices near current levels. I believe natural gas has more upside than oil in 2017, and that the average closing Henry Hub spot price will be above $3.50 for the year.

4. U.S. oil output will offset less than a quarter of the announced OPEC production cuts

From 2011 through 2015, U.S. crude oil production increased by 4.85 million barrels per day (bpd) — an average increase each year of ~1.2 million bpd. OPEC’s 2014 decision to defend market share had a chilling impact on oil prices, with U.S. oil production entering a year-over-year decline in April 2015 that continued in 2016.

OPEC’s recent decision to cut production has many predicting that U.S. shale oil producers will simply ramp up drilling, replacing the 1.2 million bpd that OPEC members agreed to cut. Some have predicted that producers could offset the entire production cut in 2017, while others (like Citigroup) see the potential for a 500,000 bpd offset if oil prices climb to $60/bbl.

I believe these projections are quite optimistic for 2017. Shale production declined by ~600,000 bpd from 2015 to 2016, and while production was turning back up at the end of the year, I don’t believe it will ramp up rapidly, for several reasons. Shale oil production will likely increase, but it can’t turn on a dime. My prediction assumes that in 2017 U.S. crude oil production will grow by less than 300,000 bpd (a quarter of the announced OPEC cut)  above the average daily crude oil production level in 2016 of some 8.8 million bpd.   

5. The total return of the Alerian MLP Index will be at least 20% in 2017

Last year I predicted that the Energy Select Sector SPDR ETF (NYSE: XLE) would rise at least 15% in 2016 as the energy sector began to recover. The XLE rose 27% on the year amid a broad energy sector recovery.

I expect to see further gains this year in the XLE, but one group that lagged last year’s energy surge was the MLPs — the master limited partnerships that still predominate among the midstream operators. The Alerian MLP Index (AMZ) was up 9% for the year, while yielding about 7%. That wasn’t terrible, but it was well behind the rising energy tide.

I expect President Trump to be extremely good for MLPs and the entire midstream space. Over the past eight years the Obama Administration has created a tough climate for energy pipelines. The resulting negative sentiment is one of the factors that have hurt midstream equities. You are going to see a great deal of top-down political support for the midstream sector over the next four years, and as a result I firmly believe MLPs will do very well in 2017. I expect the total return of the Alerian MLP Index — which consists of the price return of the AMZ and the distributions by its components — to reach at least 20% in 2017.

Conclusions

There you have my 2017 energy predictions. I believe the themes this year will be upward pressure on oil prices, U.S. shale oil producers picking up production a bit in response to the uptick in prices, increasing momentum for natural gas demand and a much friendlier federal approach to fossil fuel development. I will provide regular updates to these predictions as appropriate, but these are the final predictions I will grade myself on at the end of the year.

I believe it’s going to be a great year in the energy sector, and especially in the MLP segment. For actionable energy investing advice, please join us at The Energy Strategist and MLP Profits.    

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