Perception and Reality

by Shawn Narancich, CFA Executive Vice President of Research

Back in the Black

U.S. unemployment claims at a 43-year low, manufacturing PMI’s back in positive territory, and a five percent unemployment rate are key reasons why recent recession fears have receded. Against this backdrop, stocks are above water for the year. While retail sales, including this week’s print, have been lackluster, four percent growth isn’t terrible; and the U.S. consumer is in good shape, boosted by low interest rates, a healthy job market, and relatively low fuel prices. The domestic economy probably expanded further in Q1, though growth was likely to have been subpar. That said, a weaker dollar should help support better U.S. exports and boost this component of GDP later this year.

Earnings are the Key

With U.S. investors now having recouped early year losses, we stand by our belief that to make money in stocks this year, corporate earnings need to grow anew. We believe they will, buoyed by a more dovish Fed that has pushed the trade-weighted dollar into negative territory and by rebounding oil prices that stand to make the energy sector profitable again.

Doha for Show, Depletion for Dough

No small amount of ink has been spared prognosticating the outcome of this weekend’s meeting of oil producers in Doha, Qatar. Eighteen nations, including Russia and OPEC kingpin Saudi Arabia, will discuss a potential freeze in oil production. Despite all the press, the outcome of this confab is likely to be immaterial to oil markets since nearly every major exporter is already producing at or near capacity. OPEC member Iran, newly freed from the shackles of UN sanctions, and cartel leader Saudi Arabia, are the only two countries with any excess production capacity, at a time when low prices and weak cash flows have hamstrung drilling budgets and prevented the industry from investing at levels sufficient to offset depleting production.

The Sword of Damocles?

In the last couple months Iran has added about 350,000 barrels/day of oil to a world market that uses 95 million. However, with some of its oil having been stored in Persian Gulf tankers before sanctions were lifted, questions remain whether what was delivered is actually incremental production. After Iran picks the low hanging fruit, we are skeptical about its ability to bring production back to pre-sanction levels any time soon, given the prolonged period of underinvestment its oil industry has suffered after years of being blacklisted from the global economy. Even after the nuclear deal, Iran’s ability to use the dollar-based global banking system is impaired, calling into question the mechanics of new investment necessary to boost production, let alone who will partner with the rogue regime.

Meanwhile, Saudi Arabia has already stepped up its production over the past year and appears to have little appetite to put its remaining two million barrels/day of capacity into production amid low prices and steep budget deficits. This leaves U.S. shale, that wellspring of production that so many seem to think can be flipped on and off like a light switch. We observe that U.S. production is falling fast amid historically low rig counts and a paucity of cash flow that has banks seeking to lend less to producers under previously committed lines of credit. Stressed producer balance sheets, tight labor markets, and scrapped equipment are key reasons to believe that U.S. production declines will be slow to reverse amidst the higher oil prices we foresee.

Dawn of a New Cycle

Notwithstanding Iran and Saudi Arabia, we believe that worldwide oil supply is now falling and that continuing demand growth will consume the minimal amount of excess production that still exists, leaving global markets in deficit by the second half of 2016. Accordingly, we see global inventories beginning to decline. Thus, the lows in oil for this cycle have likely been seen, with materially higher prices closer to the $70 - $80 marginal cost of production necessary for oil markets to renew balance on the deficit side of the ledger.

Our Takeaways from the Week

  • Stocks have battled back amid stalwart economic growth domestically
  • Oil markets are tightening, regardless of the outcome of Doha this weekend