Greetings:

Two weeks ago, we sat down to talk energy with Jason Schenker, president and chief economist of Prestige Economics in Austin, Texas. He specializes in commodity markets and is known for the accuracy of his price forecasts, so when he talks about what's ahead for oil and natural gas, it pays to take note. Here are highlights of our conversation, lightly edited for clarity.

Jim Patterson: We're at $40 per barrel today [April 20, 2016] for West Texas Intermediate crude oil. First big question: A year from today, will we be higher or lower?

Jason Schenker: I think we'll be higher. And the main reason we'll be higher is we're going to see strong oil and gas demand … just like high prices cure high prices, low prices cure low prices. So you're going to see the layoffs, the downgrades, the bankruptcies, the defaults. All that stuff is just starting and it's going to continue. As it continues you're going to see reductions in additional production and you're going to see reduced future investment, at the same time when low prices are incentivizing additional demand. And so you do end up with higher prices … by this time next year.

JP: If you had to ballpark it, a year from today, April 20, 2017, what's your WTI forecast?

JS: In the first quarter of next year, we see prices on average for WTI of $45. We see an average price next year close to $50 for WTI. And that's including the fact that we see a high risk of a U.S. recession … if the U.S. does not fall into recession, then we'd see even higher prices.

JP: So say you're right on and 50 bucks is about where we end up for next year. Is that manageable for the average shale operator? Can these guys live with [oil] at $50 a barrel?

JS: You know, I think there's not one answer because there's not one kind of producer. I think at $50 per barrel, the guys who are pumping the oil are OK. If you get up to $50, you're going to see more hedging activity, you're going to see some additional drilling come on. We see prices going higher next year, but even though we've had that view, we think there could be choppiness just in the nature of the drilling and spending cycles. (Continues below.)

JP: Are there particular regions/plays where you're looking for drilling to continue to plummet? Who's going to take the hit here?

JS: I think it depends a lot on the operators and it depends on who the leaseholders are and the companies in place more than the regions. You could be in a relatively cheap region like the Bakken, but if you're overleveraged and you just had a write-down in your assets, it doesn't matter how cheap it is to drill … you might be capital-constrained and that's going to prevent more marginal drilling. I think you're going to see a lot of M&A activity. You're going to see a lot of assets change hands and a lot of consolidation.

What you really need right now is good rocks, a leaseholder that has capital to spend and an operator that can do it at a low price point. Unless you have all three of those, drilling is frozen.

There are some things that need to happen to continue to restrict supply before I'd be confident in additional [price] upside … if companies in the space continue to get beaten up, that will eventually result in higher prices. The worse it is for the industry now, the better it will be later for the guys who do make it. It's very tough right now and it's going to get tougher. They're going to be writing off billions.

On natural gas

JS: You're going to see additional marginal natural gas production diminution. You've got an industrial recession going on right now in the U.S. economy. You had the El Niño trade, which last year resulted in weak gas demand …

JP: It was 70 degrees here in Washington, D.C., the day before Christmas …

JS: So it's not cold out, you've got a lot more natural gas … none of this is terribly pleasant for producers.

JP: Do you see any price rebound for natural gas?

JS: We see higher prices by the end of the year, but it's not a massive move. As we go into the winter, we see higher prices. Q4, we see prices averaging $2.25 per million British thermal units. [As of May 3, natural gas futures were trading at $2.09 per MMBtu.] These are not terribly high prices, no matter how you slice it. Relatively, that's very low. You would need to have the most sweltering summer to see more upside for natural gas. Of course, weathermen exist to make economists look good.

JP: Longer term, there's a lot of plans to export liquefied natural gas, there's clearly a move to burn more gas and less coal. Is that enough to move the needle [on gas prices]?

JS: Even if natural gas is cheap, if oil is cheap, too, the upside to exporting gas is lower. You've seen a number of proposed terminals being mothballed. There's been a ratcheting lower of expectations for exports as a result of low oil prices.

I think the eventual future is to continue to reduce coal usage but … what does the Supreme Court have to say [about the Obama administration's crackdown on coal usage], what about a new [presidential] administration? Is it plus ça change or is it je ne sais quoi?

On the Economic Front

JP: Let's talk big picture. You've written a whole book about what people should do to prepare for what you believe is a coming recession. First, do you still see that coming, and any sense on the timing?

JS: I think there's a lot of data out there. When I look at different data, I'm very concerned …

Oil and gas is in a recession. Manufacturing is and has been in a recession. Even though it's only 13% of GDP, it is a critical bellwether for access to capital in the overall economy.

If we look at a longer-term piece of data like industrial production, it's been negative year over year for seven consecutive months. The Fed has been collecting IP data since 1919. The number of times we've had seven months of negative industrial production and we were not in or after a recession is zero. So either it's the first time in 97 years that this has happened or the U.S. economy could be in a recession.

The risk is high. There are no guarantees, but the risks are quite high.

Sincerely,

Jim Patterson

jpatterson@kiplinger.com

P.S. Don't hesitate to write me, directly with questions or comments about any of the topics we cover, or anything else energy related. You can find previous issues of Kiplinger's Energy Alerts or Kiplinger's Tech Alerts here.