On the surface, the reasoning for not having energy exposure in your portfolio seems clear. Oil prices are down over 11% year-to-date, and the energy sector is down 6.3%. This is the worst performance of the TSX’s 11 sectors.
With some sectors — like technology (up 12%), discretionary (up 12%), or even the overall S&P TSX Index (up 1.7%) — delivering solid returns, there seems little reason to invest in what looks like a failing sector.
It is important to note, however, that when the consensus is so strongly against a sector, the biggest opportunities emerge. Should oil prices strengthen, there is the potential for sector rotation to occur away from the sectors where all the money is currently parked and into energy, which will be seen as a relative value play.
Investors don’t need to look far to see an example of this occurring; last year, oil sentiment hit rock bottom in February before investors flocked back into the sector in droves.
What is holding investors back? It likely has to do with these three reasons.
Concerns over oil demand
The oil market is expected to be in deficit by over one million barrels per day in the second half of 2017, according to Bank of Nova Scotia. Goldman Sachs sees potential deficits as wide as two million barrels per day this summer.
This all hinges on strong demand growth, however. So far this year, demand growth has been fairly weak, and it has investors concerned. The International Energy Agency sees demand growing by 1.3 million bpd in 2017, but for Q1, demand growth is only expected to be about 1.1 million bpd. This is a very weak number, but it is set to improve.
Demand in the second half of the year is almost always stronger. In fact, according to GMP First Energy, since 1991 there have only been four years where demand was weaker in the second half. This is due to summer driving season and the fact that refineries do most of their maintenance shutdowns in the first half of the year.
This year’s maintenance shutdowns have been much larger than usual, which has also impacted demand. Currently, this year’s refinery maintenance season has been the largest in four years in terms of capacity offline and has also been much longer than usual. As refineries come back online (they should be online by the end of the month), demand is set to return.
U.S. production is growing
Investors are also concerned of the fact that U.S. shale production is growing steadily (it has grown from 8.9 million bpd to 9.3 million bpd so far in 2017). Some expect it to grow to 9.8 million bpd or even 10 million bpd by year end.
This much production coming online could overwhelm demand and send prices down. While this is certainly a concern, it is important to remember that U.S. shale is only 5% of global supply. It is important to look at the other 95% of global supply, which has been hit by three consecutive years of declining capital spending.
Global production naturally declines by about 3% annually, and capital is required to offset these declines. Three years of weak prices have resulted in most global production not having adequate capital to offset production declines and add to reserves to enable future production.
In addition, there are short-term limits to U.S. production growth that will keep U.S. production in check this year. Oil servicing costs are expected to grow by as much as 20% this year (the costs to drill, pump, etc.), and this will eat into available capital.
OPEC not adhering to agreed-upon cuts
OPEC agreed last fall to cut production by 1.2 million barrels per day (and is expected to extend these cuts this month). While many worry about OPEC cheating, the fact is that OPEC compliance has been excellent. In February, OPEC complied 90% to the cuts, and 104% in March. With OPEC having incentive to extend these cuts, the outlook for oil is bright.
Investors should look to play bullishness in oil with a diverse set of names. A pressure-pumping stock like Trican Well Service Ltd. (TSX:TCW) provides exposure to the growing oil production, and a name like Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) provides exposure to the U.S. and improving oil prices.