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Oil: An Oversupply Problem

Posted by Jeremy Merchant on Apr 1, 2016 5:02:36 PM
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Jeremy_branded_small_with_words.jpgEquity markets experienced a positive month in March but growth expectations continue to be limited on the upside. Two factors were instrumental in the equity market rebound since mid-February: a rebound in oil prices and a weaker U.S. dollar.

During the month of March, West Texas Intermediate crude (WTI) hit a high for the year of $41.45. Equity markets continue to be highly correlated to the price of WTI. This correlation has been high for the last 18 months and looks likely to continue in the future. However, oil prices may have hit their high in the short term as oversupply continues to be an issue. Below is a chart that helps illustrate the current imbalance between supply and demand.

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As you can see in the chart above, there is currently an oversupply of 4 million barrels of oil per day. In addition, inventories are bloated by historical standards at roughly 533 million barrels which is about 140% of their normal level (see below).

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Recently, various OPEC members have claimed that an agreement to cap production at current rates is imminent. Some analysts have used a possible agreement as an excuse to bid-up the price of oil. Others have stated that U.S. production has declined and new oil production has been shelved because new wells are not cost effective at these prices - which is largely true. However, to date, no agreement has been ratified or honored by OPEC. In addition, as of the time of this writing, Iran and Libya have refused to make any agreement until they recoup lost production brought about by years of sanctions and civil unrest. As such, a cap at these rates would only guarantee continued oversupply.

 A recent study by Bloomberg contends that the recent spike in oil prices is almost completely due to short covering as opposed to investors being bullish on the future price of oil.
 

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The study indicates that since February 2nd, contracts that were short oil have fallen by 131,617 contracts. Bloomberg also stated that a liquidation of short positions hasn't been this pronounced in more than a decade. In addition, over that same time frame only 971 long contracts (bullish positions) were issued. In essence, this analysis indicates the recent oil rally likely won't last until fundamentals catch up.

RAA continues to position the portfolios in an equity underweight/defensive posture. The main driver of the markets has been oil, and oil doesn't appear to have a fundamental reason to sustain its current rally. In addition, corporate earnings growth continues to disappoint and GDP estimates for the first quarter are a paltry 0.6%. The market is currently estimating $118 for 2016 operating earnings which we see as unattainable. In 2015, earnings were $100. This would necessitate earnings growth of 18% which would require much stronger growth than we are currently experiencing.

Please contact us at (972) 684-5923 if you have any questions.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates