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Energy stocks have turned around lately, but they have been big-time laggards this year. The sector's travails didn't start this year; it has been struggling since about mid-2014 when oil prices turned south and didn't settle down till early 2016.

The single most important variable driving energy company stocks is the price of oil. You are not to blame if you gave up on these stocks after repeated attempts over the last few years, with each attempt bringing more pain.

It hasn't been easy to make money in energy stocks lately, but we can't just walk away from a sector that accounts for the 6th highest market capitalization in the S&P 500 index out of 16 sectors in total. There are plenty of reasons to be constructive about this important part of the market.

The starting point of this discussion is to form an opinion about oil prices. Such an opinion should be informed by a clear-eyed appreciation of the supply-demand forces that drive oil prices. And that's exactly what we are doing in this note, without overly complicating the discussion with a bunch of numbers and industry jargon.

Please keep in mind that the primary fundamental problem that has weighed on oil prices over the last two years isn't from the demand side of the equation; it is from the supply side, with literally overflowing global inventories pressuring prices.

On the demand side, a steadily improving global economic growth backdrop is helping consumption. One can argue that eventually all of us will be zipped around town in self-driving electric cars, which will drive down the demand for fossil fuels. But that's far out there in the future, even if one assumes that this futuristic scenario is plausible, not just for us and other developed economies but also for the faster growing middle classes of China, India and other developing economies.


U.S. Shale Replaces OPEC

The point I am making is that you don't need to worry too much about the demand side at present. All the issues are on the supply side of the equation, which came about when shale oil producers in the U.S. took control of the global oil complex, displacing the OPEC oil cartel from its leadership position.

The oil industry always knew the existence of shale oil, but the technological challenges of producing it made it uneconomical. All of that changed with advances in fracking and horizontal drilling that made it possible to extract the previously hard-to-reach oil trapped in formations in North Dakota's Bakken region or Texas's Permian Basin, to name just two prolific shale oil regions.

Strong oil prices in the years prior to the second-half 2014 downturn created this gold-rush of drilling activities in these shale basins that pushed U.S. oil production higher after many years of declines and stagnation. Production dipped a bit in 2016, but started growing again this year as oil producers became ever more efficient. While the growth of U.S. oil production has started slowing, it is nevertheless on track to reach levels next year that haven't been seen since 1970.

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OPEC was sleeping at the switch when the U.S. shale industry took off a few years back. Ever rising production started accumulating in storage facilities, resulting in oil inventories reaching levels never seen before in normal economic times. It is these overflowing oil inventories that caused oil prices to turn south in the second half of the year.


Less Inventory Overhang

The Saudis and other OPEC members initially thought that lower oil prices will push the U.S. shale producers out of business, so they started pumping even more oil, pushing prices further down. Low oil prices produced a ton of pain for the shale producers and many of them did go out of business. But the survivors became even more efficient.

Eventually, the Saudis realized that they were in a no-win situation with the shale producers and instituted a meaningful supply cut, in concert with non-OPEC players like Russia and others. The latest iteration of this supply cut ends in March 2018, but recent public comments from Saudis and others indicate that they plan to extend it to the end of 2018.

OPEC members have a long history of cheating on previous such supply-cut decisions by the cartel, but they turned out to be unusually disciplined this time around. In other words, the announced supply cuts actually took effect and have been meaningful contributors to bending the supply-overhang curve. Global inventories are still bloated relative to historical periods, but they have started moving in the right direction in recent months.

Another factor that can potentially be helpful on the supply side is tentative signs of moderation in U.S. oilfield activity levels. Haliburton, which has its fingers on the U.S. oilfield sector, indicated in its recent earnings call that activity levels have plateaued. We see signs of this in the overall U.S. rig count as well as capital budget announcements from U.S. oil companies.


Putting It All Together

Beyond the fundamental forces discussed here are hard-to-handicap geopolitical factors that can have a bearing on oil forces. These can range from terrorist attacks and tensions in the Middle East to turmoil in Venezuela. That said, fundamental forces lead the way eventually.

It is never easy to forecast near-term oil prices. But I see plenty of reasons to be optimistic about the commodity's outlook in the wake of the OPEC moves and the admittedly tentative signs of deceleration in U.S. oilfield activity levels. This improved fundamental backdrop has helped oil prices to two-year highs in recent days.

I have been, and continue to be, skeptical of some of the overly optimistic U.S. oil growth projections that extrapolate current growth trends into the outer years. The U.S. shale oil industry has come a long way and will likely get more efficient and less costly over time, but there are limits to how much oil can be squeezed out of this very mature province. In other words - U.S. oil production can't grow forever.

The emergence of U.S. shale has reduced the odds of oil going back to $100 any time soon. But we don't need $100 oil to restore the luster of oil company stocks. All we need is greater confidence in an improving supply-demand dynamic for the commodity. A grounded view of the U.S. shale potential in a backdrop of disciplined OPEC supplies takes us to that point.


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Good investing,

Sheraz Mian

Sheraz Mian is the Director of Research at Zacks, in which capacity he leads the 60-analyst equity research team covering over 1,000 stocks, including the entire S&P 500.

He manages the Zacks Focus List and Top 10 portfolios and oversees the creation of all commentary at Zacks.com.




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