The Crude Reality of Oil’s Bear Market

Oil has garnered a lot of attention from market watchers in recent weeks after entering a bear market and posting a record 12-day losing streak from October 29 through November 13 that left the commodity 27% off its recent high.

It has been a frustrating year for energy investors because even when oil was rallying during the spring and summer, stocks failed to benefit noticeably. In fact, energy stocks have been surprisingly disconnected from oil prices for a couple of years now. As shown in the chart below, energy stocks did not get any lift from rising oil prices in mid-2017 through summer of 2018 based on relative performance of the S&P 500 Energy Index versus the S&P 500.

Some of the primary reasons for the decline include:

  • Slower growth overseas. Recent data out of Europe, Japan and China suggest overseas economic growth has slowed, which has led the International Energy Agency and others to lower global oil demand forecasts.
  • Strong domestic production. U.S. crude oil production is at a record high 11 million barrels per day, up 23% year over year and more than double the levels 10 years ago. U.S. crude oil inventories are elevated relative to their five-year averages.
  • Iran sanctions have been watered down with country exemptions. As a result, the amount of Iranian oil that has come off the global market has been less than some anticipated.
  • Production overseas is increasing. OPEC (mainly Saudi Arabia) and Russia are plugging the entire gap from Iranian production cuts and production declines in Venezuela. The U.A.E., Iraq and Libya are also chipping in.
  • Jawboning from the Oval Office. President Trump is pressuring OPEC producers not to cut, creating bearish headlines.
  • Strong greenback. Finally, a strong U.S. dollar has increased the cost of oil for international buyers in other currencies.

A long list for sure. “The recent drop in oil prices is especially surprising when considering the industry has significantly cut capital spending in the years following the oil downturn in late 2014-early 2015,” notes LPL Chief Investment Strategist John Lynch. “We could be due for a short-term bounce.”

So where does oil go from here? Our short-term bias for oil, now in the $57 range, is higher as OPEC is likely to cut production. Many oil-producing nations need higher prices to break even. In addition, oil is oversold enough from a technical perspective that we think it is due for a bounce. At the same time, as prices potentially rise, we believe prospects of additional supply increases from the U.S. and abroad will cap upside much above the mid-$60s, a view we have held throughout 2018.

The next and perhaps more important question is “will the energy sector outperform?” Our sector view is currently neutral. Though the sector may be due for some outperformance and these stocks may be pricing in a fairly pessimistic fundamental outlook, we see more compelling opportunities within other sectors, specifically industrials, financials and technology, as well as emerging-market equities. These areas are likely to benefit more from the strong U.S. economic growth outlook and a potential trade deal with China. We continue to like master limited partnerships for income-focused investors.

The best news about oil’s decline? U.S. shoppers will likely save billions of dollars at the pump and heating their homes this winter. The timing is good, just ahead of Black Friday. Remember, those sales get earlier and earlier every year. Happy shopping!

Energy Stocks Have not Kept up with Oil

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