Crude Oil: Is the Worst Over?

Guild Investment Management |

It seems that the price of crude oil may have bottomed in January, then revisited the January lows in March, and has now rallied above February’s highs. Oil stocks also arrested their decline in mid-March, and have since rallied.

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Source: Bloomberg 

From peak to trough, WTI fell 50.6 percent, and has since rallied 26.7 percent from that bottom. The SPDR Oil and Gas Exploration and Production ETF (XOP) , broadly representative of U.S. producers, dropped 34.4 percent peak-to-trough, and has since rallied 14.8 percent from that bottom -- with each recovering about a third of their decline. So perhaps the worst is over.

However, just because the worst is over doesn’t mean that sunny days are here again. We don’t believe that we’ll see significant weakening, and the arguments for $10-to-$20 oil that we saw during oil’s rout will prove to have been unfounded. Nevertheless, the recovery will be slow, with a supply and demand tug-of-war ongoing but failing to bring prices up quickly. Estimates from analysts we respect show West Texas averaging about $55 during 2015; about $67 during 2016; about $75 in 2017; and still under $100 at $81 in 2018. U.S. crude supply growth will turn negative in the third quarter of 2015, and not return to positive territory until the same time in 2016.   

There is a great deal of overhanging supply still to be worked through. Also, depending on price recovery, there will be a lot of U.S. capacity just waiting to come back online, with many breakevens estimated in the $60 range. Dynamics outside the U.S. may also continue to keep supply up and prices subdued, with Saudi showing no signs of buckling, and the OPEC cartel in disarray. Other imponderables include the ultimate issue of Iranian nuclear negotiations and the speed with which Iranian supply returns to the market, as well as events in Russia, Libya, and other potential geopolitical hotspots.

Investment implications:  The overall picture for oil is one of moderate price recovery. We think the bottom is in, but we think it’s likely that a confluence of forces -- supply overhang, a potential U.S. production revival, the return of production in Iran, continued Saudi resistance to production cuts, and the lack of concerted and effective OPEC action -- will make the price recovery slower than it has been in other cycles. Geopolitical events or an unexpected growth take-off in emerging markets could change this picture, however. With all this said, although energy stocks have had a good run, we are not ready to return to them with enthusiasm.

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