We see the recent strength in oil prices moderating over the near term. 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 below 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
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 U.S. 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 U.S. 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.
Within energy-related assets, we prefer to invest in selected equities versus oil directly. 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.
Read more market insights in my Weekly Commentary.