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Oil Is Breaking Out

By Robert Rapier on April 17, 2018

In late 2016 OPEC agreed to cut production in order to address an oversupplied oil market. Global crude oil inventories had reached record highs, and the price of oil had crashed.

OPEC’s strategy is having the desired effect. Over the past year, despite strong U.S. shale production growth, global inventories have steadily declined.

In response, global oil prices have steadily increased, reaching a three-year high last week. West Texas Intermediate closed last week above $67/bbl, while Brent closed above $72/bbl. These prices are approximately 50% higher than they were last August.

Energy Companies Moving Higher

Energy companies are on the rise but have mostly lagged the surge in crude prices. The Energy Select Sector SPDR ETF (NYSE: XLE), which represents the largest energy companies in the S&P 500, is up by only 15% since the lows of last August. The S&P Oil & Gas Exploration & Production SPDR ETF (NYSE: XOP), representative of the smaller-cap drillers, is up 27% over the same timeframe.

Master limited partnerships (MLPs), which I highlighted two weeks ago in Master Limited Partnerships Are On Sale, are finally showing some signs of life. The Alerian MLP Index (AMZ) has now outperformed the S&P 500 for three straight weeks, and last week turned in its best week of the year.

Nevertheless, there remains a disconnect between the strong rally in oil prices and the modest rally in oil and infrastructure companies. This disconnect only makes sense if oil prices will soon turn lower. But this seems unlikely.

In fact, last week Bloomberg reported that Saudi Arabia has its sights set on a target of $80/bbl. Given that Saudi Aramco is the single largest producer of oil in the world — with the power to move oil prices — investors should take this target seriously. Despite the disastrous price war on shale producers, Saudi Arabia usually achieves its aims in the oil markets.

Demand Projected to Outrun Supplies

Global oil demand is projected to increase by another 1.5 million BPD in 2018. The biggest unknown in the supply/demand picture is how much production the U.S. will add to the market.

A recent report by the Oxford Institute for Energy Studies (OIES) suggests that the role of demand in recent years has been largely overlooked. The report divides the past five years into four cycles: 

  1. OPEC defends market share from 2013-2015
  2. OPEC increases output and crashes oil prices to drive out shale  from 2015-2016
  3. OPEC/non-OPEC cuts from June 2016-April 2017
  4. OPEC’s strategy to drain global oil stocks from May 2017-present

Throughout these cycles, the report argues that demand growth has remained the underlying variable that has made OPEC’s recent strategy a success. Further, the demand story is far more important than the market realizes. 

The International Energy Agency (IEA) is projecting that U.S. production will grow by another 1.3 million BPD this year but warns of potential infrastructure limitations in the Permian Basin. This is also a topic I covered in a recent article for Forbes — The Permian Basin’s Looming Bottleneck.

The net impact of growing demand, OPEC’s supply cuts, and U.S. production growth is that the IEA projects that demand will remain ahead of supply for the rest of 2018, which will continue to deplete global crude oil inventories.


Conclusion: Oil Companies are Undervalued

If the IEA is correct, this means one thing for energy investors. Oil prices should remain strong, and will likely move higher unless U.S. production exceeds expectations this year and causes prices to crash. For energy investors, it’s just a matter of time before oil companies catch up to the rally in oil prices.  

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