Moving Energy Back to Overweight
In my May 4 blog “Moving Energy to Market Weight from Overweight,” I explained my reasons for the downgrade of the sector. This morning I am upgrading energy back to overweight -- and here’s why. The combination of declining U.S. inventories, the inability to replace Libyan oil supplies, resurgent Chinese demand, and reduced speculative long positions support my expectations that energy will begin to outperform the S&P 500® Index.
This is not an expectation for a substantial rise in oil futures. Rather, it is an expectation for modestly higher prices that will provide favorable conditions for energy equities to outperform over the remainder of 2011.
1. U.S. Oil Market
Back in 2008, the U.S. oil market properly anticipated the impending deep recession with a nearly 5% decline in demand during the summer of 2008. Concurrent with the demand falloff was the introduction of a steep contango for oil futures. Contango is a bearish condition where short-dated futures trade at a deep discount to long-dated futures.
Currently, the U.S. oil market has priced in a growth slowdown with a drop of 0.5% in demand, but it is not a condition similar to 2008. The steep contango that telegraphed the 2008 sell-off is not present.
Finally, in the past four months, U.S. oil inventories (Fig 1.1) have fallen from the yearly highs of late May. For the remainder of 2011, I expect U.S. oil demand to stabilize as we head into the seasonally strong fourth quarter. As demand stabilizes, it may further deteriorate inventory supplies.
Fig 1.1 U.S. Oil Inventories
2. China Demand
Chinese policy makers are in the midst of a tightening cycle that I expect is in the ninth inning. This month’s CPI moderation from 6.5% to 6.2% is consistent with that expectation. Investors should view an end to Chinese monetary tightening as bullish for natural resources. In fact, the most recent oil import data from China (Fig 1.2) recorded its strongest import increase since February.
Fig 1.2 China Oil Imports
3. Speculative Longs
Beginning in late February, speculators rushed to own energy. The chart below (Fig 1.3) underscores how overexposed speculative long positions became in the oil futures market. Over the past few months, those speculative long levels have normalized. Should spot energy prices appreciate further, I expect flows of capital to support the entire energy sector. Plain and simple, there is plenty of room for speculative length to be added.
Fig 1.3 CFTC Oil Futures Speculative Long Positions
Exports of Libyan oil have fallen 300,000 barrels per day from nearly 1.6 million barrels per day. Libyan oil is considered the most desirable global grade of oil and extremely difficult to replace. While events in Libya recently suggest an end to the current regime, I expect the oil recovery process to follow the same struggling path as Iraq. It is overly optimistic to expect Libyan oil exports to return to 1.6 mbd within 12 months. Rather, I expect a more likely target is half of that – around 800K. Take a look at the chart below of Iraqi oil exports (Fig 1.4). It took nearly 5 years to return to pre-March 2003 levels.
Fig 1.4 Iraq Oil Exports
5. U.S. Dollar vs. Oil Correlation
The U.S. Dollar Index has reversed its near-term bearish formation with a September surge that has advanced the Index above its 200-day moving average and is pressuring the equity valuations of multinational corporations and commodity prices. Historically, the U.S. dollar and oil prices have a high correlation. However, in this recent U.S. dollar advance (Fig 1.5), higher oil has not fallen as its historical would have and suggests that true fundamentals are supporting the sector.
Fig 1.5 U.S. Dollar Index
Fig 1.5 Oil