Why the Crude Oil Market May Be About to Give Canadian Investors a Gift

By now, it’s very clear that oil prices are in a likely sustainable bull market. Just yesterday the EIA released their weekly numbers, which again showed U.S. oil inventories being drawn down by 1.4 million barrels. While this was lower than expected by about 1.6 million barrels, it occurred even though demand from refineries shrank and imports grew. U.S. production continued its steadily decline, falling every week since January

With global oil companies having an estimated average breakeven price of $70-80 per barrel, oil prices will need to rise in order to encourage investment to meet demand. However, this rise will not occur in a straight line and prices will likely improve in a very uneven manner.

Oil prices typically rise and fall in cycles (for example, last March oil prices rallied from $44 up to $60 by May, stagnated for the summer, and then plunged to $38 in August). Petroleum geologist Art Berman suggests these cycles typically last four to five months, and that a downward move is likely due before the next part of the upward cycle begins.

Here’s why fundamentals could support such a move and why Canadians should use this pullback to pick up high-quality names in the financial and energy space.

There are some bearish forces on the horizon

Firstly, while U.S. shale production has been in a constant decline (declining over 450,000 barrels per day since January), more decline needs to occur in order to offset new supply coming online from OPEC and non-OPEC producers. Prices rallying too prematurely can lead to a slowing or even reversal of this decline.

For example, U.S. driller Pioneer Natural Resources has recently stated in an earnings release that if oil stays around US$50 per barrel and has a positive outlook for supply and demand, it would consider adding five to 10 more drilling rigs. The company stated it is not necessarily the US$50 level that is important, but rather that the supply/demand outlook is stable enough to support prices in that range. This seems to be the case now as there is little fundamental support for oil prices to move and stay below US$40.

While an increase in the rig count does not necessarily mean more production, the market would view a reversal of the decline in rig count as being bearish. Analysts at the Bank of Nova Scotia recently stated that an increase in rig count would be “significantly bearish.”

Similar to Pioneer, Canadian producer Crescent Point Energy Corp. has also stated that it would consider more capital spending and drilling activity in the second half of the year if prices remain stable.

When this is added to the fact that the current rally has also been fueled by a series of temporary supply outages, the possibility for a downward move grows.

How to take advantage

If oil prices do decline, Canadian bank stocks would be one place to look. Currently, Canadian bank stocks are more correlated to oil than ever before with the correlation reaching 0.65 (with one being a perfect correlation). This is an all-time record.

If oil prices decline, Royal Bank of Canada (TSX:RY)(NYSE:RY) could see a significant pullback due to its oil exposure (3.6% of its oil and gas loans were impaired compared to 2.1% for its peers) and exposure to Alberta.

Currently RBC is trading at about 11.1 times its 2017 earnings, well below its long-term average of 11.6 times. Even a small pullback from current prices of around $78.80 to around $76 would lead to RBC trading at 10.7 times 2017 earnings, which would mark a very attractive entry point.

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Fool contributor Adam Mancini has no position in any stocks mentioned.

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