OPEC's Early Holiday Gift

by Jason Norris, CFA Executive Vice President of Research

Ferguson Wellman has viewed the energy sector favorably for close to two years. While 2015 was a difficult year in that regard, we started seeing improvements in 2016. Finally, OPEC delivered a nice gift earlier this week which will continue to benefit our stance.  Below are comments from our internal energy analyst, Shawn Narancich, CFA.

"Oil ministers from the 14 producing nations of OPEC held their much anticipated 171st meeting earlier this week, agreeing to reduce their cumulative daily output by 1.2 million barrels per day (MMb/d). Additionally, non-OPEC member Russia, the world’s largest oil producer, agreed to reduce its production by 600,000 b/d.

If realized, these production cuts would amount to a significant 1.9 percent of global oil demand, more than enough to reverse what modest amount of overproduction remains. The OPEC agreement formalizes the production cut agreement reached in Algeria two months ago, but at the top end of the 750,000 to 1,200,0000 b/d plan, and represents the cartel’s first production cut since 2008.

Speculation about the deal outcome resulting in anything tangible was neutral to negative into the opening trade on Wednesday, so oil markets were caught off guard, with crude oil rising nine percent. What we got is the analogue opposite of what OPEC delivered that fateful day two years ago, when members agreed to absolve themselves of any active management of oil markets.

Oil industry observers will now shift their focus to compliance – will OPEC deliver the cuts they proclaim? While OPEC’s history of compliance is mixed, production has tended toward quota over time. In this case, the production cuts are planned for a six-month period beginning January 1. While OPEC has created a Ministerial Monitoring Committee to watchdog the accord internally, monthly OPEC production reports will undoubtedly fall under greater scrutiny in the New Year. OPEC next meets on May 25, 2017, and has the option to extend the production cuts by another six months.

If the cuts are achieved, removing 1.8 MMb/d of supply will leave the oil market in significant deficit next year and put a material dent in surplus global inventories. Presuming three percent global GDP growth supporting another 1.2 MMb/d of demand in 2017, oil prices stand to top $60 next year. 

Just as importantly, incremental supply from long cycle oil projects (deep water and Canadian oil sands, for example) that has continued to bleed into markets will disappear, and the $400 billion of cap ex cuts the industry has endured over the past two years will be felt more acutely. Since new oil from legacy projects has helped delay the re-balancing of oversupplied oil markets in 2015 to 2016, one should presume the opposite effect in an undersupplied environment of rising oil prices. 

These developments are good news for Ferguson Wellman’s overweight to energy and our beta-weighted holdings therein."

Should we just put a bow on it?

Including the post-election rally, the S&P 500 now has a gain of over 10 percent for 2016, should investors take profits or continue to move money into equities. We view the market as fairly valued after recent strength and would not chase at current levels. However, since investors had been under-invested in equities and the calendar looks favorable, we would not sell here.  Below is a chart from Strategas highlighting the percentage of time stocks are positive each month. As shown below, December has the best batting average with stocks rising 75 percent of the time.

This recent strength has also resulted in a spike in interest rates. The 10-Year Treasury Yield has moved up from 1.85 percent to 2.4 percent in the last month. Retail investors had been continuously buying bond ETFs and mutual funds since 2009. It is going to be interesting to see if these investors start chasing equities when their bond funds are showing losses of over three percent for the fourth quarter. This is one of the many reasons we focus on individual bonds which allows us to reinvest maturities at higher interest rates.

Takeaways for the Week:
·    While stocks aren’t cheap, we believe there is still room for upside in December
·    Energy stocks should continue to rally as investors close out their underweight