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Shopping for Discounts in The Markets – Could Oil Be a Gift that Keeps Giving?

It’s hard not to recognize that the global equity markets have had a tremendously positive year in 2017.  All sectors tracked by Sector SPDR’s have a positive return this year.  There is one laggard for 2017 – the energy space.  Let’s take a look to see if this could present an opportunity for outperformance as we look forward to 2018.

It hasn’t been easy to make money in energy stocks lately as is evidenced by an overall 2017 return of just .13%.  That being said, we might not want to turn our backs on a sector that accounts for the 6th highest market capitalization in the S&P 500 index out of 16 sectors in total. There are plenty of reasons to be constructive about this important part of the market.  Please keep in mind that the primary fundamental problem that has weighed on oil prices over the last two years isn’t so much a lack of demand for this commodity but rather too much supply with global inventories pressuring prices.

How did this supply imbalance come to be?  The oil industry always knew the existence of shale oil, but the technological challenges of producing it made it economically unfeasible. This dynamic changed as advances in fracking and horizontal drilling made it possible to extract the previously hard-to-reach oil in areas such as North Dakota’s Bakken region or Texas’s Permian Basin. Strong oil prices in the years prior to the second-half 2014 downturn created a rush of drilling activities in these shale basins that began to push U.S. oil production significantly higher.  Overflowing oil inventories caused prices to turn south in the second half of 2016.  So how did the OPEC members react to this oversupply situation?  They produced, even more, oil!!  While counterintuitive on the surface, their thought was that lower oil prices would push the U.S. shale producers out of business as keeping the pumps flowing lowered prices for the commodity even further. While low prices produced much pain for the shale producers- some of them going out of business – the survivors became even more efficient. Realizing that this was becoming a no-win situation, the Saudis, OPEC members, and Russia all agreed to output cuts. The latest iteration of this supply cut ends in March 2018, but recent public comments from Saudis and others indicate that they likely plan to extend it to the end of 2018.  At the same time, we are seeing tentative signs of moderation in U.S. oilfield activity levels. Haliburton indicated in its recent earnings call that activity levels have plateaued. We see signs of this in the overall U.S. rig count as well as capital budget announcements from U.S. oil companies.

Does this portend oil prices rising back to $100 anytime soon?  Unlikely.  On the demand side, a steadily improving global economic growth coupled with supply side balances is helping consumption. One can argue, however, that there may come a day when we will be moving around our cities in self-driving electric cars which will drive down the demand for fossil fuels. That’s likely far out there in the future and doesn’t account for other developed economies’ oil demands as well as faster growing middle classes of China, India and other developing economies.

Here’s the best news of all… we don’t need $100 oil for the beleaguered oil sector to begin to shine in 2018.   Greater confidence in an improving supply-demand dynamic for the commodity should suffice to allow opportunities for investment in this sector next year.  Combine this fundamental backdrop with a thorough knowledge of utilizing option spreads for all market trends and give your portfolio the gift that keeps giving in 2018.

By Karen Smith

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Karen Smith

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