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Beleaguered oil patch investors will need to be patient, but a compelling bullish case for the oil price and energy stocks is not hard to build.

In the current market, the supply glut is all-pervasive but the accompanying top chart suggests it may not last. The chart shows the Baker Hughes index of active U.S. oil rigs compared with U.S. oil production in millions of barrels per day. The production data are pushed forward by six months to account for delays between oil rig reductions and weekly oil production.

The historical trend strongly suggests an imminent, large drop in oil production. The number of active rigs has declined by more than two-thirds since September, 2014, from 1,609 to the current 510. If historical patterns hold, the amount of U.S. oil produced could fall from 9.2 million barrels a day to somewhere in the six-million-barrels-a-day range. Admittedly, a cut of this magnitude is unlikely. A U.S. production drop of even one million barrels a day would push oil prices higher, and make further declines in drilling activity less necessary. Such a drop in output would go a long way to alleviate oversupply conditions.

Many indebted U.S. shale oil producers are struggling mightily to avoid bankruptcy in the current commodity price environment. An early-year CNBC report cited predictions that fully 50 per cent of U.S. shale firms were at risk of going out of business. It's not difficult to imagine financial failures on this scale leading to major declines in oil supply.

The second potential driver of an oil price rally is related to the first. Namely, that the plunge in industry profits has resulted in a lack of investment that will limit future supply.

For many investors, the current oversupply of oil obscures the fact that global crude demand continues to climb. The U.S. Energy Information Administration writes: "EIA estimates global consumption of petroleum and other liquid fuels grew by 1.4 million [barrels a day] in 2015, averaging 93.8 million b/d for the year. EIA expects global consumption of petroleum and other liquid fuels to grow by 1.4 million b/d in both 2016 and 2017."

There is too much oil in global markets now, but investment targeted at finding and developing new reserves will be necessary in a few short years to meet the steadily increasing demand. But instead, the difficult conditions for oil producers have led to a large-scale reduction in exploration-focused investment. Reuters reports that major U.S. companies have cut investment budgets by 25 per cent and Royal Dutch Shell PLC has announced a $5-billion (U.S.) reduction in spending.

The lower chart shows the global oil supply and demand forecasts as calculated by the EIA. The projections imply the end of glut conditions – a balance of supply and demand – by the first quarter of 2017. In my opinion, the risk is that after that point the lack of corporate investment will have the market shift quickly to a shortage of crude, and sharply higher commodity prices.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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