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Is Sentiment Toward Energy Stocks Catching Up With Fundamentals?

By Elliott H. Gue on Apr. 16, 2018

Although oil prices aren’t immune to the occasional selloffs on days when traders reduce exposure to risk assets, the fujndamental and technical picture looks relatively sanguine.

Many commentators chalked up last week’s big rally in crude prices to the chemical weapon attack in Syria, the US response and the risk of further deterioration in US-Russian relations. Saudi Arabia also intercepted a missile launched by Yemeni rebels, who reportedly receive support from regional rival and fellow OPEC member Iran.

These events sparked familiar talk about the rising geopolitical risk premium in global oil markets, which pushed prices sharply higher.

Although increasing geopolitical tension might explain part of the upside in crude, attributing this move solely to developments in the Middle East belies improving fundamentals in the market–namely, tightening in the supply-demand balance for oil.

The shape of crude-oil futures curves support our outlook.

The main reason we turned bullish on oil in the second half of 2017–after three years of bearishness–was that the Brent futures curve shifted from contango to backwardation.

When a market is in contango, the front-month contract trades at a discount to longer-dated futures. This scenaio signals that an oversupply of crude oil has depressed near-term prices, creating an arbitrage opportunity whereby market participants to store the commodity and sell at the higher futures price.

In a backwardated market, the front-month contract commands a premium relative to longer-dated futures, incentivizing market participants to draw down inventories. Backwardation often occurs when the supply-demand balance in the oil market tightens.

When oil prices rallied last week, the degree of backwardation for Brent and West Texas Intermediate (WTI) crude oil also increased. For example, WTI for delivery next month fetched a more than $6 per barrel premium to the May 2019 futures contract. For Brent, this spread stood at roughly $5.50 per barrel.

Meanwhile, OPEC”s monthly report on the global oil market suggests that the market has tightened at a faster-than-expected pace. The organization’s latest projections call for global oil demand to exceed 100 million barrels per day in the fourth quarter of 2018. On the year, oil demand is expected to increase by 1.63 million barrels per day. Demand growth of more than 1.5 million barrels per day is considered robust.

OPEC production continues to decline, fueled in part by Venezuela’s economic collapse. The South American country’s oil output sits almost 500,000 barrels per day below the level contemplated by OPEC’s November 2016 production agreement. Sadly, a quick resolution to Venezuela’s political crisis appears unlikely; even in the best-case scenario, the country’s oil output probably will fall further this year.

Saudi Arabia’s oil exports to the US continue to hover around the lowest levels in 30 years. At the same time, US shale producers have started to experience some headwinds from cost inflation, insufficient pipeline capacity and moderating efficiency gains.

 

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