Oil's Down but Not Out

 | Mar 27, 2017 | 1:00 PM EDT
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March has been a tough month for oil and oil stocks. It seems like the rally in the stock market, inspired by the new president and his pro-business agenda, and the rally in oil prices, inspired by the OPEC production cut in December, have both run out of steam. 

Measuring all the negatives that are affecting oil and oil stocks is hard. The recent setback in a new health care bill has been the biggest indicator that the new president's agenda may not be easily enacted. That has spooked the stock market in general and sent indexes reeling, affecting oil stocks as well. 

As for oil specifically, the focus of most oil analysts has been on the swelling of U.S. stockpiles and the likelihood of an OPEC extension of its production cuts in early June.

Let's take each of these in turn, as well as throwing in a less-discussed factor -- the speculative bettors. 

There can be no denying that U.S. stockpiles have been swelling. Shale producers have been spending the last two years whittling down working assets to only the most efficient and productive wells. However, once oil prices finally rose above $50 again, many of these producers saw that as a go signal to put everything they had back online. The results have been predictable: Rig counts are up nearly 200 since their lows were recorded, oil production in the U.S. is again approaching 9 million barrels a day and storage is near its limit.

This notably bearish resurgence of shale output has been the major focus of analysts -- a shortsighted view, in my opinion. U.S. production, as impressive as it is, hardly tells the full story of global supply and demand. While U.S. production has revived much faster than I expected, it still is only responsible for at most 600,000 barrels a day being added to the global supply. Meanwhile, OPEC retains the important stopgap to continued production gluts. 

And here is where the analysts are similarly focused -- on whether the OPEC cuts begun in November will be extended in June. There is a long history of poor cooperation inside the cartel, making analysts wary (and bearish) of continued compliance and even more suspicious of an extension. But there is ample reason to believe this extension will be agreed upon. Compliance from OPEC members has been unprecedented, in the 95%+ range, with the Saudis going above 100% and delivering even more of a cut than they originally promised. For the Saudis, there is the overwhelming need for higher oil prices ahead of their Saudi Aramco IPO coming in early 2018. Even the Russians, despite their lower 68% compliance, are promising better adherence to promised cuts.

And finally, financially, there has been a huge speculative long position from hedge funds that has been retired in the last several sessions. This may be the best indication that oil prices are only taking a temporary setback, as it has become practically impossible for oil prices to rise while overwhelming long positions have dominated the futures markets. This rebalancing toward a more neutral financial position is much more likely to result in constructive price performance going forward. 

While the analysts are laser-focused on OPEC and domestic stockpiles, I believe they are looking at only short-term factors that will disappear in the coming weeks. Stockpiles are only temporarily swelled and OPEC is sure to extend its production cuts. It's tougher to tell if the stock markets at large will maintain their strength or continue drifting lower, but for oil bulls, this is likely to be a nice opportunity to add some quality oil stocks to your portfolio.

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