Where oil prices are headed, and why

Positive news for oil investors came out of the June 22 Organization of Petroleum Exporting Countries (OPEC) meetings, says Brian See, vice-president of equities at CIBC Asset Management.

OPEC nations announced a commitment to 100% compliance with its 1.8-million-barrels-per-day production cut originally agreed upon in late 2016.

Over the last year and a half, production cuts actually reached 150%, says See (June 23 meeting notes from OPEC say participating countries “exceeded the required level of conformity that had reached 147% in May 2018.”). “So, instead of 1.8 million barrels of a production cut into the market, there was actually [a cut of] 2.7 million barrels,” he says.

Complying with original cuts will amount to a roughly one-million-barrel-per-day production increase, beginning July 1.

The overcompliance was mainly due to countries like Venezuela seeing supply “falling off at a larger pace than anticipated, and also a lack of reinvestment among other countries, causing their oil fields to decline,” See says.

The cumulative effect of that was “oil inventories [fell] from historical highs to below five-year averages. We also saw [more] consumption of gasoline and distillates from the end consumer, and this led to oil prices rallying from the low US$30s all the way up to US$75, and even touching US$80,” he explains.

As of June 26, WTI was trading above US$70 while Brent crude was trading above US$75.

Ahead of the OPEC meeting, markets had called for an increase of around 600,000 to 700,000 barrels per day to be brought on, so the resulting announcement came as a surprise, See says. “This was because, if you look at the one million barrels per day, certain countries can’t even bring on that capacity. They don’t have the spare capacity.”

More details are expected in September, when OPEC and non-OPEC nations will meet to further discuss quota and output levels, and review production levels.

While a rise in prices and consumption was needed in terms of balancing the market in 2016, higher prices can also lead to “to possible demand destruction in the case of end consumers,” See says. “We have started to see this coming out from customers in China, India and even the U.S.”

An increase of production from OPEC nations is welcomed because it “will ultimately lead to more of a balanced oil market on a go-forward basis,” he says. In particular, See points to Saudi Arabia as being the primary contributor to the increased production.

That country plans to ramp up crude oil production for July to record levels. As Bloomberg reports, sources familiar with Saudi Arabia’s output policy suggest the country’s aiming for its “biggest-ever export surge” to help cool oil prices. State oil company Saudi Aramco will lead the charge, Bloomberg adds, at about 10.8 million barrels a day, surpassing previous highs.

It’s really the “only the major player that could have brought on that production,” See says.

He’ll continue to monitor the situation, he says, but finds OPEC’s moves are, overall, “a positive development for oil markets.”

Geopolitical pressure

One geopolitical issue to watch is the Iranian nuclear deal, See says. The U.S. backing out could “lead to pressure from the European nations to purchase their crude elsewhere, outside of Iran. It will be interesting to see which OPEC nations pick up the slack from decreasing Iranian volumes,” he says.

On June 26, CNBC reported the U.S. could turn to Russia, despite “thorny” relations, “as the U.S. attempts to cut off Iran from the world oil market.”

Another issue to monitor is Venezuela’s continued production decline due to the “economic and political chaos,” See says. “We’d expect production to keep falling there.”

Other political hot spots include Libya and Nigeria, which saw their production ramp up during this time of cuts. “They’ve been facing a steady stream of rebel attacks, which could lead to production falling offline on a quick basis; that’s something to monitor,” See cautions.

Mexico and the U.S. are also top of mind. For the former, production has fallen and a general election is coming up on July 1.

In the U.S., shale production is a major market concern. “U.S. oil production is at more than 10 million barrels per day and continues to grow,” See says. Now, the market “is facing constraints due to pipeline capacity issues in the Permian Basin [located in Texas and New Mexico] and in Cushing [located in Oklahoma].”

However, “we think these constraints will be alleviated in the second half of 2019, and the U.S. will continue to grow,” See predicts.

So, where’s oil headed?

See’s expectation for oil prices is they’ll remain within the US$60-US$70 range, “and that’s the update we gave last time. We see that continuing in the foreseeable future.”

Also, WTI oil will keep trading at a discount to Brent, he adds, “just because of pipeline constraints in North America, specifically out of Canada, the Permian Basin and Cushing.” In an effort to get landlocked Alberta oil to market, the Canadian government agreed to buy Kinder Morgan’s Trans Mountain pipeline and related infrastructure for $4.5 billion.

Read: Liberals’ $4.5B Trans Mountain purchase ‘an investment in Canada’s future’: Morneau

In the CIBC Energy Fund he manages, See says, “We favour [exploration and production] as a subsector to go to, just because [today’s] price levels allow these companies to execute their business plans and offer competitive rates of return. In addition, these companies are also doing shareholder-friendly actions such as debt reduction, share buybacks and dividend increases.”

This can lead to outperformance, he says, noting two examples of names he’s watching are EOG Resources and Anadarko Petroleum, both based in Texas.

On energy as a whole, he’s positive. “We think energy should continue to do well, post this OPEC deal.”

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.