Where are prices of oil and related assets headed after this year’s rally? Higher, we think. [Here's why.]

Written by Terry Simpson, CFA, CAIA

[As illustrated in the chart below,] crude oil has risen nearly 15% since the Organization of the Petroleum Exporting Countries (OPEC) agreed to cut oil output. We believe that the deal has put a floor under oil prices, and that this will help bolster prices of related assets. Skepticism on the implementation of the deal abounds, as OPEC has had a poor record of keeping to production quotas, but we think that OPEC members are likely to stick to the agreement this time, as the cartel appears keen to rein in global oversupply and stabilize prices. [As such,] we see oil trading in a range of $50 – $65 a barrel throughout 2017. The pace of an ascent to the top end of this range will likely depend on how quickly the global oil market moves from oversupply to a deficit. We see this happening in the first half of 2017. A key risk to this scenario would be increased production from Libya and Nigeria—two OPEC countries exempted from the agreement.

Oil equities and debt

Stronger oil prices should benefit North American energy equities, especially the low-cost producers that focus on on-shore projects, we believe. These producers are better positioned to navigate shorter cycles in the supply-demand dynamics of the oil market. Refiners could benefit too, if global oil demand surprises on the upside. We’d shy away from larger integrated oil companies, as their often costly off-shore projects make them less nimble.

The OPEC deal could provide an incentive for North American shale producers to crank up output, evidenced by a growing oil rig count. We think such worries are overblown. Our estimates show that any U.S. production increase will likely be modest, as it takes four to six months for companies to ramp up production. By then, it could be welcomed by the market to offset a decline in oil inventories and to help prevent oil prices from rising too much. Excessively high prices could spur high-cost oil producers to increase production, and in turn push prices downward.

We see few opportunities in the U.S. high-yield bond market. We are neutral on U.S. high-yield energy debt after a big run-up this year, believing the OPEC deal is now fully priced in. A sub-index of energy, the metals and mining sectors of the Bloomberg Barclays U.S. Corp High Yield Index, now offers the same yield as a sub-index of non-commodity-related sectors—a development not seen since late 2014.

If oil prices were to climb to $65 a barrel next year, we could see Canadian stocks extending their 2016 outperformance and the Canadian dollar receiving a boost. Energy represents about a fifth of Canada’s market cap and earnings growth is very much tied to fortunes in the oil patch (nearly half of the expected 22% earnings growth for the S&P/TSX Composite Index in 2017 flows from the energy sector, we calculate).

Outside the oil complex

The importance of oil as a macroeconomic variable could provide a boost to assets outside the oil complex. Higher oil prices would support reflation: higher growth and higher inflation...A few asset classes stand out:

1. U.S. cyclical equities. Oil demand has remained strong throughout the economic recovery. Further demand growth could signal that the economy is moving to the next leg of the cycle. Cyclical sectors such as materials could benefit, in our view.

2. Treasury Inflation Protected Securities (TIPS) could become popular. Investors are likely to adjust their inflation expectations if oil prices stabilize or rise further. We recommend substituting nominal U.S. Treasury exposure for inflation-linked bonds.

3. Many emerging market (EM) countries tend to benefit from positive investor sentiment when commodity prices are rising. We see opportunities in commodity exporters, especially in high-yielding debt from EM resource exporters. Selection is key when investing in EM asset as higher oil prices are unlikely to lift all boats. For example, the long-term correlation between broad EM equities and oil prices appears to have weakened recently.

Our bottom line:

Oil and related assets have more room to run.