Oil is breaking out, but can the momentum last?
Martin Pelletier explains the factors that could determine if this rally is different
Oil prices have had a great run recently, gaining over 35 per cent from their early summer lows, recouping all of their year-todate losses and reaching levels last seen in July 2015. This is good news for investors in the sector who have had a real rollercoaster ride over the past four years, with $105 per barrel highs and $26 per barrel lows before prices settled into a $45 to $55 per barrel range beginning May 2016.
However, the breakout this week above the $55 per barrel ceiling — oil topped US$57 on Monday — leaves many wondering if this current momentum is sustainable. In our opinion, there are three main factors worth keeping a very close eye on to determine whether this rally will differ from others in the past or return back to its range as tensions begin to ease and/or U.S. shale output expands.
GEOPOLITICAL RISKS
There is a lot going on in the Middle East these days.
The Iraqi Kurds voted for independence back in September with the Iraq government responding by seizing the city of Kirkuk and all of the surrounding oilfields that come with it. In total, the northern region of Kurdistan in Iraq currently produces more than half a million barrels per day of oil, or roughly 12 per cent of the country’s total output. It gets even more complicated considering Turkey is the only way to export oil from that region, so any increase in unrest could result in a meaningful disruption in supply
Then there is Saudi Arabia: With the latest roundup of elites and the deaths of two Saudi princes, it is starting to look a lot like an episode of Game of Thrones. All of this comes as they are preparing the IPO of Saudi Aramco.
Adding fuel to the fire, Iran is being accused of taking advantage of the Saudi instability by providing missiles to the Houthi rebels in Yemen used in this weekend’s attack near Riyadh’s airport.
Any further escalation on this front could send oil prices much higher.
IMPROVING FUNDAMENTALS
The global economy is well past the road to recovery with the number of countries in a recession falling to its lowest level in decades, according to a report from Deutsche Bank. Add in rising currencies against a falling U.S. dollar to the expected four per cent growth in global GDP and the case for more robust global demand for crude oil gets even stronger.
On the supply side, the surplus has been eliminated thanks to cuts by OPEC and falling global output, bringing the world finally back into balance. Looking ahead, we think the key will continue to be U.S. output, which has been a thorn in OPEC’s side and is still setting new 2017 highs at 9.55 million barrels per day.
That said, while the rig count is starting to contract with another drop reported last week it remains 62 per cent above last year’s levels. U.S. E&P have also been vastly outspending their cash flows so capital markets in the form of debt and equity will need to continue to be available in order to fuel this growth.
THE CYCLE
Commodities and especially oil prices tend to rally in the later stages of a bull market as inflationary pressures start to take hold. Interestingly, both Canadian and U.S. producers’ share prices have not kept pace with the recent rebound in oil prices and are still down eight to 15 per cent while oil prices are up nearly nine per cent this year. Compare this to the S&P 500 that is up over 15 per cent this year. According to BlackRock and as cited in MarketWatch, the energy sector is currently trading at a 40-per-cent discount to the broader S&P 500 compared to the longer-term average of a 17-per-cent discount.
Therefore, it wouldn’t surprise us to see investors begin to rotate into the sector pushing both oil and oil stocks higher especially among the many managers underweight the sector. The only caveat to this would be a broader market correction that is long overdue given the S&P has been setting new records for levels of complacency.
In conclusion, the recent turn in oil prices is a positive development for Canadian investors and the energy heavy S&P TSX and there appears to be some momentum building. The big question is if the geopolitical instability, improving fundamentals and attractive valuation is enough to keep it above the recent trading range. Financial Post Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.