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By Dave Meats, CFA | 08-14-2017 02:00 PM

Energy Investors Should Be Cautious Amid Supply Questions

We see room for oil prices to fall, but think some shale producers still look attractive over the long term.

David Meats: By voluntarily curtailing production by 1.8 million barrels a day through March 2018, OPEC and its partners have engineered a supply shortage to drive down inventories. And after a slow start, the strategy seems to be working--U.S. inventories have now fallen 11% since March 2017, and global stocks could reach the five-year range by the end of the year. However, we think the recent ramp in U.S. shale activity will trigger substantial production growth going into next year that could overwhelm oil markets, if the OPEC cuts expire as planned. Therefore, OPEC must decide whether to hand over a portion of its market share to the shale industry or deal with more oversupply.

Further cuts may be rational in the short run. The market responded with a 14% price hike when the cuts were initially announced, outweighing the 5%-6% average volume sacrifice made by participants. However, history suggests that cutting production is not always an effective strategy. For example, Saudi Arabia reduced its output every year from 1981 to 1985 in an attempt to protect crude prices. The rest of OPEC was initially on board as well, but only for a year or two, and the strategy failed miserably. In that period prices fell every year regardless, and the cuts exacerbated revenue losses for Saudi in particular (and adding insult to injury with a significant loss of share). Something similar could theoretically play out anyway in the next few months because the upcoming Aramco IPO gives Saudi an incentive to prop up near term prices. But it isn't clear whether the kingdom is willing to go it alone, and even if its partners agree to participate further they could eventually lose patience with the strategy, and cheat.

Our assumption for now is that OPEC will allow these cuts to expire during 2018, adding 1.8 million barrels a day to the market at a time when shale volumes are growing rapidly. Therefore, we recommend caution. A handful of low-cost shale producers, like RSP Permian and Diamondback Energy, do look attractive for long-term investors, and these firms have the balance sheet strength to endure another bout of oversupply, if need be. But stocks are highly correlated with commodity prices, which means even these standout picks could struggle in 2018.

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