Why OPEC’s Latest Deal Virtually Guarantees a Rally in Baytex Energy Corp.

The market may not have appreciated it, but OPEC’s recent agreement to extend production cuts by nine months removes a key risk from the oil market and will lead to a rapid draw-down in oil inventories and an increase in price. For names oil-leveraged names such as Baytex Energy Corp. (TSX:BTE)(NYSE:BTE), this means upside.

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The Organization of Petroleum Exporting Countries (OPEC) met once again on May 25 in a highly anticipated meeting that was widely expected to determine the course of oil prices for the rest of 2017 and into 2018. After the meeting concluded, oil prices proceeded to plunge nearly 5%, as the market was largely unimpressed with the agreement OPEC produced.

OPEC agreed to extend the 1.2 million bpd production cut agreed on in November 2016 for additional nine months (the agreement spanned the first six months of 2017). It is important to remember that only a few months ago, the market was uncertain if OPEC would even extend the agreement for another six months.

As the meeting approached, however, it became clear through a series of statements that not only would the market get a six-month extension, but there was strong support for a nine-month extension. Oil rallied, and this rally was extended by rumours that OPEC was planning on deepening the cuts past the 1.2 million bpd determined in November.

With a nine-month cut priced in, and the market eagerly anticipating an additional surprise, the market sold off sharply on the news that an agreement has been reached, despite the fact only a few months ago, such an agreement would have been considered tremendously bullish.

Regardless of the market’s short-term view on the agreement, the impact over the next several months on oil-leveraged names like Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) will be tremendously bullish.

Imports to the United States should drop sharply

Oil’s weak performance lately is due to several factors, but a key factor is that U.S. crude inventories — sitting at 516 million barrels — are 107 million barrels above the five-year average. The market has been skeptical of OPEC because even though the production-cut agreement has been in place for five months, U.S. crude inventories are barely off the all-time high of 535 million barrels set at the end of March this year.

This means that for the first three full months of the agreement, U.S. inventories actually rose steadily. Does this mean OPEC was cheating?  It doesn’t, because OPEC compliance with the deal was excellent. According to the Secondary Sources table of OPEC’s monthly report for April, production for OPEC, excluding Libya and Nigeria (which were exempt from the deal), was 29.6 million barrels per day. This is down 1.56 million barrels per day from October 2016, well exceeding the target 1.2 million barrels per day.

The reason U.S. inventories have not fallen is because key OPEC producers — like Saudi Arabia — cut production, but did not cut exports. They instead drew down their own inventories to keep revenue coming in. With inventories depleted and Saudi Arabia entering its high-demand summer season, OPEC will have no choice but to cut exports.

OPEC recently acknowledged this, and Saudi Arabia’s energy minister stated that exports to the U.S. would drop “measurably.” Saudi Arabia knows it can’t support the oil market with just words anymore, and the only way to improve prices is to cut inventories in the United States.

This means investors should see oil prices rising over the coming weeks and months (especially since U.S. storage usually draws down at this time of year).

Baytex Energy Corp. will benefit

Baytex is potentially Canada’s most leveraged oil producer. If oil rallies, Baytex is almost certain to rally to an exaggerated degree. The stock is down 43% off December highs, and it may be a smart seasonal play. With oil inventories seasonally declining until the end of October, Baytex will have an enormous tailwind, reducing risk and increasing potential reward.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini owns Baytex Energy Corp. shares

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