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Energy outlook for 2016: Looking for a bottom

Talk of production cuts by global oil producers such as Russia and Saudi Arabia have provided a few jolts to the price of oil this year, but the rallies have been short-lived. The dynamic in the oil market continues to be dismal, with the price of West Texas crude still hovering around $30.

"It felt like we jumped off a bottom, but we've felt that before," said Stewart Glickman, an energy equity analyst at S&P Capital IQ. "Thirty dollars is an unreasonable price for oil, but sometimes extreme volatility can outweigh fundamentals."

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The collapse of the oil market and the plunge in stock and bond prices across the energy sector might be a great opportunity for value investors, but Glickman is still cautious. "As much as stocks have been beaten up, the fundamentals have had it worse," he said. "We're still underweight the energy sector, because there's a lot more pain to come."

The reason is a stubborn oversupply of oil in the global market, thanks largely to the "fracking" revolution and the explosive growth of U.S. oil production. In the last five years, it has increased from just over 5 million barrels per day to nearly 9.5 million barrels. With Organization of Petroleum Exporting Country members, such as Saudi Arabia, and big non-OPEC producers, like Russia, refusing to cede market share to U.S. producers, the supply imbalance got worse through 2015.

It may not be as bad as the supply glut in the 1980s that took more than a decade to work through, but the current situation will cause further volatility in the oil price. The oversupply is currently about 1 million barrels per day in production, according to market analysts. The International Energy Agency's forecast of 1 million to 1.2 million barrels in new demand this year may be high, but if it isn't, the excess supply could be worked off fairly quickly.

In the short term, however, the oversupply will persist. When oil refiners go offline in early spring for maintenance, crude inventories will build further.

In addition, with Iranian oil set to come onto the market now that sanctions have been lifted — as much as 1 million additional barrels over the next 18 months is forecasted — the glut could grow.

Between those two factors, we could see a lot more volatility in prices over the next three months," said Harish Sundaresh, a portfolio manager with the Alpha Strategies Group of Loomis Sayles.

Sundaresh, however, is confident that oil will be trading above $40 by the end of the year, with the potential to rise further in 2017. A big reason for that is the looming shakeout in the U.S. production industry.

"If we're right on our outlook — which includes a modest slowdown in the economy — there's room for very big improvement in the energy sector." -Marshall Adkins, managing director of energy equity research at Raymond James

The resiliency of the U.S. exploration and production companies has been remarkable, but 2016 will be a year of reckoning for the industry. Roughly 40 exploration and production companies and 40 oil-service and -equipment companies defaulted on their debt last year and are in some form of reorganization.

Many more will soon hit the wall.

"There's going to be a lot of pain this year," said Becky Roof, a managing director at global consulting firm AlixPartners. "Companies need new business models to get through the next couple of years."

Research from AlixPartners on 130 publicly traded U.S. and Canadian E&P companies suggests that, at these price levels, they will have a combined $102 billion operating cash-flow shortage to cover interest expenses and capital budgets.

"We advocate a zero base [capital expenditure] budget for clients now as opposed to starting with last year's budget," Roof said.

Producers have already been rationalizing resources and mothballing unproductive wells to reduce expenses. While U.S. oil production ticked up slightly last year, there was a drop in production of almost 300,000 barrels in the last two months of the year.

Market analysts expect another reduction of up to 500,000 this year. With most producers getting significantly less than the $30 per barrel WTI benchmark price, the number of operating oil rigs has been falling rapidly.

As of Feb. 19, there were 514 operating oil rigs in the U.S., according to oilfield services company Baker Hughes.

That's almost 800 fewer than the same time last year, and the number could fall significantly further, according to Marshall Adkins, managing director of energy equity research at Raymond James. "If the current [oil price] holds for much longer, we could get down close to 300 operating rigs," he said.

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Adkins, however, sees the best performers in the industry poised to thrive when market conditions improve.

"It's horrible out there now, and there will be a lot more bankruptcies, but companies with good balance sheets and a clear path to get through the next six months will do well in the recovery," Adkins said.

Adkins' optimism is based on the fact that horizontal drilling techniques have helped U.S. oil companies become the most efficient producers in the world. When prices recover, they will benefit most.

"The U.S. industry has doubled production in the last five to six years, and the productivity of rigs is up 15 to 20 times," he said. "It's been a staggering shift in the business."

Picking the winners, however, is a high-risk game for investors. Companies with the strongest balance sheets will have the opportunity to buy up competitors or at least their assets at discounted prices, but the risks in the short term remain very high. "You could hit a home run, or you could strike out," said Glickman at S&P Capital IQ.

If you have the stomach for more volatility in the short-term, Atkins suggested that an energy sector fund — ideally focused on E&P producers — should do well in the next two years. He also thinks master limited partnerships, most of which are not levered to the price of oil, have been dragged down in sympathy with the rest of the energy market.

The demand for energy infrastructure will boom in 2018, and MLPs currently offer great value, he said.

"If we're right on our outlook — which includes a modest slowdown in the economy — there's room for very big improvement in the energy sector," Adkins at Raymond James said. "We'll be wrong if there's another meltdown in the U.S. economy like 2008."

— By Andrew Osterland, special to CNBC.com