For qualified investors

A taming of the oil bull

20-Nov-2017
By BlackRock Investment Institute, Richard Turnill

Key points

  1. We expect the recent strength in oil prices to moderate over the near term and prefer to get our energy exposure in selected equities.
  2. Risk assets sold off before recovering later in the week. Japanese stocks were the laggard. US consumer inflation data mostly met expectations.
  3. Minutes from the Federal Reserve’s previous policy meeting are likely to further boost markets’ already high expectations of a December rate hike.

A taming of the oil bull

We see the recent strength in oil prices moderating over the near term. Within energy-related assets, we prefer to invest in selected equities versus oil directly and maintain our neutral stance on high yield energy debt.

Chart of the week
Brent crude oil price and OPEC production cuts, 2016-2017

Chart of the week

Sources: BlackRock Investment Institute, with data from Thomson Reuters, November 2017.
Notes: The green line shows brent crude future prices. In November 2016, OPEC members agreed to cut oil production by 1.2 million barrels per day, and non-OPEC participants by roughly 600,000 barrels. The agreement was extended in May 2017 and assigned an expiration date of March 2018. OPEC will next meet on Nov 30, 2017.

The Organization of Petroleum Exporting Countries (OPEC) meets later this month, and the market is largely expecting oil production cuts to be extended, potentially through the end of 2018. Oil prices, however, look different going into this meeting than they did before the previous two OPEC meetings, as the chart above shows. Oil prices were lower and more volatile then, and cuts were aimed at rebalancing supply and demand to prevent further price declines. This time around, the market rebalancing has occurred and oil has rallied ahead of the meeting. Brent crude, the global benchmark for oil prices, hit a 2.5-year high earlier this month. We could see limited upward price movement if OPEC proceeds as expected and downside risk to oil prices if no extension is announced.

Gauging signs of a slowdown

We’ve seen this sort of asymmetric price movement before: Prices rose in anticipation of past production cuts, only to fall or trade flat after OPEC delivered. With cuts priced in, a failure to deliver this time could be all the more painful. Some are betting oil prices will rise further over the short term: Speculative long positioning is at record highs in the futures market. Reinforcing the bullish view: improved global demand for oil just as supply has fallen. An OPEC extension of production cuts would further supply-demand rebalancing.

But we see reasons to believe price gains will moderate even with an OPEC extension. Major global oil agencies predict non-OPEC supply will rise next year, pressuring oil prices. Increased hedging activity in the futures market by US shale producers may signal an intent to ramp up production, we believe. A clearing up of logistical bottlenecks caused by recent hurricanes should also boost US oil exports, increasing global supply. However, heightened tensions in the Middle East between Saudi Arabia and Iran and greater-than-expected oil demand could push up prices over the near term. Longer-term challenges to oil include the rise of electric vehicles and other lower carbon methods of transport.

We prefer tech and financials in equities, but are finding more opportunities within the energy sector in the belief that companies have shifted to capex discipline – and away from a growth-at-all-cost mentality. We like global integrated oil companies. Some are improving cash flows, and the group has lagged recent price gains in exploration and production companies. We are neutral toward high yield energy bonds and prefer the exploration companies relative to service companies in this space. The former has stable cash flows whereas the latter struggles to gain pricing power.

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  • Risk assets sold off at the start of the week but most recovered. Japanese equities were the laggard. Japan’s third-quarter private consumption fell more than expected. Retail sales and industrial production data in China also missed expectations.
  • The US Consumer Price Index generally rose as expected, demonstrating that inflation is modestly bouncing back from early-year weakness. The nominal US bond yield curve flattened. US inflation-linked bonds barely budged.
  • The US House of Representatives passed its tax reform bill, while the Senate’s version advanced further toward a final vote. The fifth round of NAFTA renegotiations kicked off in Mexico.

 


  Date: Event
Nov. 22 FOMC minutes, US durable goods orders; UK Autumn Budget
Nov. 23 Eurozone Markit flash services and manufacturing PMIs
Nov. 24 Japan Nikkei flash manufacturing PMI; US Markit flash manufacturing PMI

The minutes from the Fed’s Oct. 31-Nov. 1 meeting are likely to stoke markets’ already high expectations that the central bank will raise interest rates in December. We see the Fed following up with two to three rate increases in 2018, barring any unexpected shocks to US growth or inflation. Major developed markets’ Purchasing Manager Index (PMI) data are likely to provide more evidence that the global economy is experiencing a sustained economic expansion: Economists expect the indexes to come in around last month’s mid- to high-50s levels. Readings above the 50-mark signal expansion.

Richard Turnill
Managing Director, is Global Chief Investment Strategist for BlackRock
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...

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