Oil In Purgatory: Where is the Bottom?

By Shane Obata, CFA and Chris Kerlow, CFA

 

In the first half of 2014, the oil outlook was bright

Prices were rising, companies were investing and free cash flow was gushing. The good times were expected to last; on June 30th , 2014, the average analyst oil outlook (West Texas Intermediate, “WTI”) was to remain above $92 through 2017.

Unbeknownst to most, the world was on the verge of an epic battle among oil producers who sought to increase production and market share. Supply was rising faster than demand and people were starting to worry about a ballooning oil inventories. Saudi Arabia, haunted by its past mistakes and determined to maintain market share, chose not to cut production to address the glut and instead continued to pump. The goal being to push higher cost shale production out of the market. These developments led to a massive slide in oil prices, which fell from over $100 in the first half of 2014 to a low of $26.05 on February 12, 2016 – the point of maximum pessimism.

Subsequently, oil rebounded as sentiment improved. U.S. production began falling and some investors hoped that OPEC would intervene. That is exactly what they got in November 2016, when OPEC agreed to curtail production. The agreement pushed WTI above $50 a barrel, where it held until March this year. Optimism was back in the market that rebalancing was on the way. OPEC was helping and supply would fall below demand, to help address the global glut in oil inventories.

Recently this optimism began to fade

U.S. production was rising again and there were concerns that OPEC members who were exempt from the production quota might offset Saudi Arabia’s best efforts. Rebalancing has been moving farther away and sentiment has been worsening. On May 25, OPEC and non-OPEC members agreed to extend production cuts for nine months. Unfortunately, that was not enough for the market. As we write, oil has fallen to $43.18. That is 22% lower than the high of $55.25 on January 3rd , 2017. Prices have fallen back into a bear market and we are concerned about more downside. Still, our recommendation is the same as it was on January 30th , stay underweight energy and focus on defensive names.

 

 

 

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Learn more about Redwood Tactical Asset Allocation Fund (RTA) and Redwood Core Income Equity Fund (RDE)

 

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