Fundamentals for oil and gas stocks still challenging

We think that a couple of short-term factors have driven up the price of oil and the shares of oil and gas stocks. But oil supplies are likely to remain too high. Oil demand is likely to turn out lackluster. Ride out the ongoing downturn with solid producers.

West Texas Intermediate, or WTI, crude is the benchmark for North American oil prices. It has surged. At US$36.50 a barrel, it’s up by 40 per cent from its low of close to US$26 a barrel in February.

Western Canadian Select, or WCS, oil trades below WTI’s price. Still, the jump in WTI has raised the price of WCS. It has jumped from a low of less than US$14 a barrel to US$24.80 a barrel. Higher oil prices sent up the share prices of Canadian oil and gas stocks.

Two short-term factors have raised oil prices

The partial recovery in oil prices likely reflects a couple of short-term factors. First, financial markets tend to overshoot fair values. It’s likely that the price of oil was sent down more than was warranted. So some recovery makes sense. But markets may soon overshoot the price of oil to the upside.

Second, selling oil short was a ‘no-brainer’ way to make money for a long time. That’s no longer the case. Some speculators closed out their short sales by buying back oil. With the price of oil jumping, more speculators are likely to close their short positions. This has added to the recent buying.

In the long run, however, the price of oil essentially reflects the fundamentals of supply and demand. We think that the fundamentals haven’t changed that much in recent days. There’s still an oil glut.

Iran wants to rebuild its production and exports, with the lifting of sanctions against it. This member of OPEC (the Organization of Petroleum Exporting Countries) could add a lot to the supply of oil. Saudi Arabia and Russia might retaliate by raising their own production and exports. Their agreement to potentially freeze their production was contingent on other producers doing their part.

Even if Saudi Arabia and Russia do freeze their production, it may have little impact. After all, they would freeze production at the January levels. This high level of production played a role in knocking down the price of oil. Saudi Arabia’s and Russia’s production might fully offset cuts by those with higher costs—such as Canadian producers.

Shale oil production in the U.S. can adjust quickly to changes in prices. If oil prices rise, then it creates an incentive for shale oil production to recover.

Lackluster demand for oil

The demand for oil largely reflects how fast the global economy grows.

One pattern is worrisome: economic growth forecasts start robust. Then they’re cut. The Economist shows 2016 forecasts for inflation-adjusted Gross Domestic Product growth in 16 economies. Nine were cut from the previous forecast. None were raised. Canada’s real GDP is now expected to grow by 1.6 per cent in 2016—down from 1.8 per cent previously.

As the industrial world ages, economic growth slows. Other big economies are troubled. Brazil’s economy is expected to shrink by 3.2 per cent this year; Russia’s to shrink by 1.3 per cent; China’s will grow ‘only’ 6.4 per cent.

Lackluster demand for oil and growing supplies is likely to keep a lid on prices.

To the extent that you buy oil and gas stocks today, stick to safe producers such as Key blue chip stocks Imperial Oil (TSX─IMO) and Suncor Energy (TSX─SU). True, they’ll jump less than marginal producers when oil prices rise. But they’ll also weather the industry setback better than most.

 

The Investment Reporter, MPL Communications Inc.
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