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Portfolio Update

Value Play Earns Higher Buy Target

By Elliott H. Gue, on Oct. 11, 2017

West Texas Intermediate (WTI) crude oil prices snapped a roughly month-long winning streak last week, ending Friday’s trading session at $49.29 per barrel—slightly above the commodity’s 50-day moving average.

We regard recent weakness in the commodity as a modest technical pullback within the context of a longer-term recovery.

The financial media cited a variety of factors to explain last week’s decline in oil prices. Toward the end of the week, the chatter focused on Hurricane Nate and its implications for energy-related operations and infrastructure on the Gulf Coast. In our view, Nate’s effects on US oil production, consumption and refining capacity will pale in comparison to Irma and Harvey.

Libya’s oil production also rebounded quickly from a short-lived shutdown of the nation’s largest field, while Saudi Arabia’s output also increased in September. These developments weighed on investor sentiment.

Nevertheless, oil-market fundamentals have continued to heal, suggesting that the September rally wasn’t just another false dawn.

For one, Brent crude oil remains in backwardation, a condition where near-term contracts trade at a premium to those further out on the curve. A backwardated market encourages participants to withdraw oil from storage, reducing inventories; paying to store oil only to sell it at a lower future price would be the definition of a bad trade.

WTI, on the other hand, is in contango for the front few months of the curve and enters backwardation further out. We chalk this anomaly up to hurricane-related disruptions that resulted in refinery outages and temporarily increased storage volumes.

The price differential between WTI and Brent has widened to $6 per barrel, an unsustainable level that’s roughly 2 times the norm. In response, the four-week average of US oil exports last week surged to a record 1.294 million barrels per day. Over time, increased US exports will draw down domestic inventories, narrowing the discount at which WTI trades relative to Brent.

Bottom line: The backwardated Brent curve reflects a tightening supply-demand balance; WTI eventually should follow Brent higher, once hurricane-related disruptions ease.

Higher-than-expected US oil production remains a risk, though the number of rigs targeting this hydrocarbon has declined by about 20 from the August high. Meanwhile, the number of drilled wells awaiting completion continues to climb in some active basins.

Historically, US oil output has responded to changes in the rig count with a 20-week lag, suggesting that volumes could start to moderate sometime next month. Apache Corp (NYSE: APA), Parsley Energy (NYSE: PE) and a handful of other exploration and production companies have also lowered their output guidance, citing disruptions related to Hurricane Harvey.

Although WTI has rallied above the psychologically important $50 per barrel in recent weeks, the risk-reward balance for the commodity skews to the upside over the next six to eight months.

The decline in the US oil-directed rig count signals that producers have reined in their horns a bit, while Libya and Nigeria—both of which continue to produce near peak levels—remain prone to security-related disruptions. Meanwhile, the socioeconomic and political environment in Venezuela continues to deteriorate.

Against this backdrop, we’d argue that WTI could approach $60 per barrel over the coming six to eight months, though this move won’t occur in a straight line and the timing remains uncertain.

Shares of exploration and production companies have responded to the rally in oil prices and enticed value-oriented investors to rotate into the space, propelling some stocks to valuations that would keep us on the sidelines.

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