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The Oil Euphoria

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1The Oil Euphoria Empty The Oil Euphoria Mon Dec 05, 2016 9:34 am


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This past Wednesday, OPEC finally reached consensus on oil production cuts agreeing to collectively reduce output by 4.5%, or 1.2 million barrels a day.

This sent oil prices soaring. By the close of the market Wednesday, crude prices had rallied over 9%—the biggest one day gain since February 12—and oil and gas producers had accounted for all of the day’s 10 best performers in the S&P 500.

But the euphoria surrounding this announcement that’s pushing prices higher won’t last.

The aim of the cartel’s production reduction are two fold: to end the oil supply glut and to get barrel prices rising again.

This new output reduction deal is contingent on both OPEC members living up to the agreement, and on the cooperation of non-OPEC oil producing countries. Countries like Russia and the U.S.

Despite prices still being less than half what they were just 2 years ago, prices have jumped from where they were at the start of the year, which will only make U.S. shale producers more eager to drill. It’s anticipated that U.S. shale fields could raise production within 4 months, with Texas coming online sooner to capitalize on its $900 billion Permian Basin.

Russia has said that it will cooperate with OPEC and reduce its output. The problem with this is that Moscow is notoriously hard to predict, and considering how much low oil prices have impacted the Russian economy, it isn’t hard to imagine a scenario where Russia takes advantage of marginally higher barrel prices, agreement be damned.

These two players aside, Morgan Stanley also sees an increase in investment from Asia to the North Sea, which will limit oil’s upside even further.

With the OPEC agreement taking affect on January 1, 2017, what I imagine we’ll see is oil advancing to around $60 per barrel early in the year, however, the reduction is only in effect for 6 months after which either OPEC members will agree to extend the agreement because the glut is still there as a result of the rest of the world not reducing output in the first six months of the year, or they won’t extend the agreement and soon after the glut will return in force. Either scenario will have oil retreating back to $50 per barrel by the end of next year, or potentially even slumping down into the $40 range.

Perhaps the agreement’s short time frame is a clever trick OPEC hopes will limit the upside for non-members inhibiting market-share gains especially in the U.S.

But taking a step back, with all things considered, the size of the cut, the timing of it, and the length of time of the reduction is all somewhat trivial in a 96 million barrel per day marketplace with or without non-OPEC member cooperation.

As the agreement doesn’t go into effect until the start of 2017, it’s member countries have been ramping up production in anticipation. Saudi Arabia’s production has increased to well over 10 million barrels per day. Other OPEC countries have followed suit—including Iran which is trying to reclaim its global market share and clout within OPEC that it lost under the western sanctions related to its nuclear program—making the glut far worse before the agreement goes into effect and setting it up to be less meaningful.

The 4.5% cut in production is a great headline, but adherence by member countries isn’t a given. The three big Persian Gulf producers, Saudi Arabia, Kuwait, and the United Arab Emirates, account for roughly 60% of the cuts and are expected to adhere fairly closely to it. But the other member producers may not adhere as closely to their production limits, and without that adherence, the cuts don’t have much teeth.

So it seems as though OPEC’s agreement is just noise meant to bring movement to crude oil prices in the short term, and drive a sentiment shift in oil and energy stocks.

The big problem with this strategy is that it is so focused on the short term. The glut will still exist, and its doubtful prices will ever rise to where they were two years ago. And the big problem with all of this supply, and part of the reason why the glut of oil exists in the first place, is that the demand just isn't there.

While it’s true that the glut in oil can be partially attributed to OPEC member states’ unfettered oil production since 2008—the last time a production output reduction was put in place—it’s also true that with rise of electric and more efficient gas-powered passenger vehicles, and solar and wind power, oil demand has begun to slow enough to make even the chief financial officer of Royal Dutch Shell, Simon Henry, predict that we’ll reach peak oil demand within 5 to 15 years.

Even the International Energy Agency (IEA) thinks oil demand from passenger cars, the biggest users of oil, has already peaked. In the IEA’s World Energy Outlook released in November, it doesn’t imagine the global demand peak coming before 2040, but their forecasts have underestimated growth in the renewables industry for the past decade causing me to think their forecast is a little too optimistic for oil and energy companies.

Add to this that global trade has already plateaued and it’s possible that with the rise of nationalist leaders such as President-elect Trump, we’ll see further declines in trade, reducing the demand for oil from the freight and maritime sectors.

Between the rise of electric passenger cars and renewable energy such as wind and solar, and the decline in demand from global trade, it’s hard to envision where demand will come from for oil. While it’s expected that emerging markets will drive future demand growth, I have to wonder if these markets will be able to drive it fast enough to depress the other apparent trends.

What it all comes down to is that in the long term, oil really doesn’t seem like a safe bet. And to me, it feels a bit like OPEC is fighting against history.

Having said that, though, I do believe that with all of this OPEC noise, there are some opportunities in the short term.

One such opportunity is U.S. Silica (SLCA).

I like SLCA because, while it’s in the oil and energy sectors, it isn’t dependent on producing fuel for passenger cars, the area where peak oil demand has already been reached. Instead, SLCA manufactures commercial silica used for fracking and other industrial processes.

Beyond its operations in the oil and gas industry, it also provides silica products for use in plastics, rubber, cleansers, paints, sealants, and fiberglass and other textiles. With its spread across these segments, when peak oil demand is reached in the coming years, SLCA won’t be in the kind of trouble pure oil producers will be.

SLCA has done really well this year. It bottomed out of a multi-year downtrend at the beginning of this year, rising from the low teens to just over $51 per share as I’m writing this.

Typically I wouldn’t recommend a stock that has been steadily rising like this one has, but I still think there is a fair amount of upside to SLCA and this week it set up an interesting opportunity.
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Looking at SLCA’s chart over the last couple of months, you can see that this week it broke out of a correction, making for a great entry point for a breakout trader.

Furthermore, if the price can rise above its all-time high of $73.43—roughly 30% above where it is now—there is no more overhead resistance for SLCA.

You have to anticipate a correction before it gets there, but if you place a stop loss around $48 - $49—its low at the beginning of this week—and adjust that stop loss as the price rises, you should mitigate the risk.

Bottom line, betting on oil in the long term isn’t such a great idea. With demand weakening, oil and gas stocks won’t be a safe place to have your money within a few short years.

But there are opportunities in the short term, and companies like SLCA are a safer option than pure oil plays that are still benefitting from all the OPEC noise.

source: investiv

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