Crude oil started off the week by breaking out of the narrow range it has been stuck in since January. Unfortunately for oil bulls who were hoping that oil would break from its $51-54 range to approach $60, oil moved in the opposite direction with an 8% drop to $49 per barrel.
For holders of Canadian energy stocks, this is just another headwind among many. Canadian oil stocks are already down, in many cases, well over 20% year-to-date (Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) is down 35% year-to-date). This decline in Canadian energy stocks has occurred despite oil essentially being flat for the year up until recently.
The fact that oil was holding up seemed like the one positive thing going for Canadian oil stocks, and with oil now declining, many oil investors may be thinking of moving on. Here’s why this is a mistake.
The oil price decline is temporary
Why did oil prices just plunge 8%? Prior to the decline, investment funds were holding record levels of long (or bullish) positions in crude oil. With so many investors positive on crude, it takes very little to trigger massive amounts of selling if the price moves the wrong way.
This is exactly what happened.
The trigger in this case was an 8.2-million-barrel build in U.S. crude oil inventories last week. Analysts were expecting a build of about one million barrels; crude inventories are still rising despite the fact that OPEC has recently cut 1.2 million barrels per day of production. Rising inventories means there is too much crude oil.
This build in inventory is partly because, according to analysts at Bank of Nova Scotia, many refineries are still offline due to maintenance season, meaning demand for crude oil from refineries is currently at the seasonal low. From this point, it will steadily increase until the summer.
In addition, OPEC spiked production in December (before their cuts took place), and this is just starting to appear in U.S. oil inventories now (since it takes about two months for production to actually reach the U.S.).
Going forward, refinery demand will steadily grow, OPEC’s production cuts will begin to appear as inventory reductions, and the fact that many funds have reduced their exposure to oil means that there is more money sitting on the sidelines ready to be deployed into oil once inventories start to decline.
It is important to remember that OPEC is complying with their promised production cuts (and are likely to renew them), and that outside the U.S., oil inventories are falling. Oil demand is expected to be strong in 2017 and 2018, and this should support prices as well.
Canadian energy stocks should recover
Canadian oil stocks have largely sold off due to fears of a border adjustment tax. Such a tax would mean that U.S. refineries that buy Canadian oil would need to pay additional tax, incentivizing them to purchase American oil instead.
It is not certain if such a bill will pass — especially considering the strong opposition — and it is also uncertain if it would include oil since that would hike gasoline prices for U.S. consumers. Even if the bill is passed, it is unlikely to affect Canadian oil that much, since U.S. refineries rely on Canadian heavy oil and the U.S. produces very little of it.
Baytex is a smart way to play this trend. Baytex actually produces half its oil in the U.S., which means part of its production would not even be affected by a border adjustment tax. It has sold off more than most of its peers, making this a perfect opportunity to acquire Baytex shares at a discount.
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Fool contributor Adam Mancini has no position in any stocks mentioned.