OPEC: bullish for oil prices, even more so for oil shares

OPEC’s deal to cut oil output for the first time since 2008 sent the oil price soaring, and oil stocks have begun climbing again. There’s plenty of optimism the global market will now re-balance in 2017, but a lot will depend on whether OPEC members stick to their new quotas. An expected uptick in US production will also cap oil price gains.

Oil barrels
Source: Bloomberg

The market was expecting some sort of a ‘vague’ agreement around a production cut, but instead it got a concrete and coordinated narrative with detailed production cuts even for the more unsure members such as Iran and Iraq. Saudi Arabia and allies like Kuwait and Qatar are shouldering the bulk of the cuts, and will be banking that lower production is more than offset by a higher price per barrel. Only Nigeria and Libya are exempt from the deal, which in total should cut OPEC production by 1.2 million barrels a day to 32.5 million barrels a day.

Russia, not part of OPEC, has pledged to increase its production cut to 300,000 barrels a day for the first half of 2017, from between 200,000 and 250,000 previously. There will now be a non-OPEC meeting on 9 December, which Algeria, Venezuela and Kuwait will also attend. OPEC will meet again at the end of May 2017 to discuss a potential extension of the six month deal for a further six months.

OPEC watchers are already questioning whether individual members will stick to the agreement. Nigeria and Libya have the greatest potential to increase output and they are exempt. But the apparent output cut for Iran could also actually lead to a small increase in output because of uncertainty over the numbers being used to base the country’s new output ceiling on. The other question is whether non-OPEC producers will stick to their side of the deal. Will Russia deliver on its 300,000 barrel a day cut, half of the total non-OPEC supply cut?

Technical analysis

Overall, this remains as bullish as it could get for oil prices. The WTI light sweet crude oil price should go for a third retest of the year high around $52, and this time it has a good chance of breaking it.  The weekly chart has been shaping up a significant reversal pattern from July to August 2015 with an inverse head and shoulder. A break of the neckline would open the way to next resistance at $60-62. The width of the head and shoulders pattern leads us to a potential target of $75.

However, oil prices seem capped to the upside over the longer-term, as US producers continue to drive down their costs through technological advancements. There’s already evidence that US rig counts are starting to rise again and that’ll feed through to more production over time. The SP500 exploration and production companies might be a better way to play the oil price rise, as they are able to benefit from both higher oil prices and lower costs. A study from Goldman Sachs shows how the cost curve has gone down significantly over time for US shale producers. They expect productivity gains to continue at a rate of 3% to 10% per year until 2020, a reason why they expect oil prices of no more than $50 by then. 

The XLE energy ETF has already broken the reverse head and shoulder neckline on the upside, confirming a bullish picture. 

Weekly XLE/SP500 spread chart: Note the XLE has also reversed a multi-year underperformance versus the S&P500.

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