5 Things Core Laboratories N.V.'s Management Wants You to Know About What's Actually Going On in the Oil Market

By Matthew DiLallo Markets Fool.com

Image source: Getty Images.

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Core Laboratories (NYSE: CLB) literally has its ear to the ground when it comes to deciphering what's going on in the oil market. The company studies oil reservoirs, which tell it what's happening with production, giving it a deep level of understanding on the supply side of the market. Core Labs takes what the reservoirs are saying, compares this with other data, and then blends it into an informed macro view of the oil market, which CEO David Demshur shared on the company's recent quarterly earnings conference call. Here are five things he says the reservoirs are telling us about what's really going on in the oil market.

Goodbye, oil glut

Demshur started off with a bold statement:

Core believes that the worldwide crude-oil markets are currently undersupplied as indicated by several consecutive months of declining worldwide crude-oil inventories. We believe the projected December draw will be the fifth consecutive month in a row. Projected OPEC cuts of 1.344 million barrels of oil per day and other cooperating countries pledging to cut another 600,000 barrels of oil per day will lead to extended worldwide inventory declines and the continuing rally in oil prices and energy prices in 2017. As Core has continually stated, the Middle East was producing oil at unstable levels. We are sure that some of these cuts were more than welcome by several Middle Eastern producing countries. All that Core did was listen to the reservoirs and not the rhetoric.

As Demshur points out, oil companies have produced less than market demand for five straight months, with the shortfall accelerating as a result of the OPEC cuts. Furthermore, in his view, one of the drivers of OPEC's decision to cut output was the fact that its reservoirssimplycould not continue pumping at full tilt. That understanding of Middle Eastern oil reservoirs informed the company's view that supplies would continue coming down, eating into the oil glut.

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U.S oil output is starting to come back

Demshur then turned his attention to U.S. supplies, noting:

Also importantly, U.S. crude production peaked at 9.7 million barrels a day in March of 2015 and then declined approximately 1.3 million barrels a day into December of 2015. At that time, Core calculated a U.S. net decline curve rate of 11% per annum. U.S. crude supplies have increased on a net basis for October and November in response to increased activity levels, largely in the Permian Basin.

U.S. producers hit their peak more than a year ago with production steadily coming down since then due to under-investment. However, the industry has recently started ramping activity back up in an attempt to push back against the natural production decline. For example, leading U.S. driller Devon Energy (NYSE: DVN) reduced its rig count from 40 in early 2015 to five by the third quarter of 2016. As a result, Devon Energy's third-quarter production from retained assets declined 6.9% year over year. However, Devon Energy has started adding back rigs now that oil prices have stabilized above $50 per barrel and it expected to end 2016 running 10 rigs, with plans to run 15 to 20 by the end of this year. These rigs should push its production up by a low- to mid-single-digitrate this year.

The Gulf disappointed

Demshurthen turned his attention offshore:

In 2016, production gains in the Gulf of Mexico were disappointing. Originally projected by Core Lab to add 200,000 barrels of production per day during 2016, the production added was essentially flat to up slightly year over year owing to larger than expected activity declines and less production addition from legacy deepwater projects. 2017 is off to a better start as BP's (NYSE: BP) Thunder Horse South complex, completed ahead of schedule and under budget, is set to add 40,000 barrels of new 2017 production.

The Gulf of Mexico was supposed to offset some of the production declines from shale plays, but it failed to do so last year. That pushed U.S. production down more than expected. While Gulf production is off to a good start this year thanks to the early start-up of BP's latest project, the Gulf cannot make up lost ground as fast as shale due to the long lead time of offshore projects.

Image source: Getty Images.

Starting to fall behind

Demshurcontinued dissecting the oil market:

Globally, Core estimates that the net decline curve rate is currently approximately 3.3%. Applying the 3.3% net decline curve rate to the worldwide crude-oil production of approximately 85 million barrels a day means that the planet will need to produce an additional 2.8 million barrels of new oil by this date next year to maintain current worldwide productive capacity totals. With limited long-term sustainable spare production capacity, coupled with the aforementioned production cuts, Core believes worldwide producers will not be able to offset the estimated 3.3% net production decline curve rate in 2017, leading to a further decline in global crude-oil production. Also weighing on future production capacity is the fact that operators discovered less than 4 billion barrels of new oil in 2016, while the globe consumed over 55 billion barrels. Therefore, Core believes crude markets more than rationalized in late 2016, and price stability, followed by price increases -- some occurring as we speak -- are returning to the energy complex. Remember, the immutable laws of physics and thermodynamics mean that the crude-oil production decline curve always wins and it never sleeps.

Core Labs' CEO makes two key points. First, producers are not expected to invest what it would take to drill the wells needed to offset the natural decline rate of legacy oil reservoirs this year. Second, oil companies did not come close to discovering enough new oil to replace consumption last year. In fact, it was the industry's worst year for exploration since 1940. These two factors lead to one conclusion: Oil prices must go up, which would then incentivize the industry to invest the capital needed to meet current and future oil demand.

The V-shaped recovery has officially arrived

That led Demshurto conclude:

As projected by Core in early 2016, the third quarter of 2016 marked the bottom of the V-shaped recovery which is now under way. This recovery should continue to strengthen with higher commodity prices and subsequent activity levels as 2017 progresses.

Core has pounded the table for the past few quarters that the oil market was not only nearing a bottom but that it would bounce back sharply after bottoming out. Fueling that view was what the oil reservoirs were saying about their ability to supply the market and not OPEC's rhetoric or what analysts thought would happen. Clearly, the reservoirs have spoken, which leads Core to confidently conclude that oil prices and therefore industry activity levels should march higher in 2017, allowing the sector to revive its forsaken reservoirs.

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Matt DiLallo owns shares of Core Laboratories. The Motley Fool owns shares of and recommends Core Laboratories. The Motley Fool owns shares of Devon Energy. The Motley Fool has a disclosure policy.