DOES OPEC’S PRODUCTION CUT PRESENT AN INVESTMENT CASE FOR ENERGY EQUITIES?

By Michelle McGrade, chief investment officer of TD Direct Investing

As we now know, an agreement was reached among the OPEC (Organisation of the Petroleum Exporting Countries) members to cut oil production on 30th November, which saw oil stocks surge to the top of TD Direct Investing’s most traded list.

Michelle McGrade
Michelle McGrade

In the first hour of trading on Thursday, 1st December, Glencore and Premier Oil (AIM-listed) were the top two most traded stocks, followed by BP, Tullow and Royal Dutch Shell. They alone have accounted for over 20% of trades in the first hour, with a ratio of two buys for every three sells – highlighting both profit-taking and confidence that there will be further rises. It has sent the price per barrel soaring too, with brent crude now sitting comfortably at $54.84 (correct as of 10:29 on 6th December, 2016), breaking the $55 mark for the first time since July 2015.

However, while this is creating a trader’s paradise, there is a cautionary note to consider about the longer-term impact on the UK economy. It’s been clear for some time that the low price of oil has been hurting oil producers. So, in my view, it was a matter of time before OPEC decided to cut production. So far these are words only though, proof of whether they will act accordingly is yet to be seen.

A higher oil price, together with a strong US dollar, makes things tougher for UK consumers because not only will petrol be more expensive, but this combination could fuel a stronger surge in inflation than originally expected. Inflation is highly correlated to the oil price.

Source: Bloomberg as at 30th September 2016
Source: Bloomberg as at 30th September 2016

Past performance is not a reliable indicator of future returns

The managers of the Guinness Global Energy fund say a reduction in OPEC and non-OPEC production now provides a clear path to a tightening oil market next year, claiming that there is a precedent for this, looking back to 1998/99. Oil prices troughed in late-1998 and then recovered as the market tightened, with global oil inventories returning to their normal operating levels by the end of 1999.

This is a significant positive for sentiment towards energy companies, say the Guinness fund managers. In the 1998/99 period, energy equities outperformed world equities in the subsequent periods after the oil price low. Today, the weight of energy equities with the S&P500 index is still close to multi-decade lows and valuations are bouncing off similar levels to 1998/99. If you believe, as the Guinness fund managers do, that this news helps on the path to recovery in the oil price to $70 plus a barrel, the case for energy equities at this level looks strong.

This upward movement in the price of oil means that the Chancellor of the Exchequer, Phillip Hammond’s promise to freeze the duty paid on oil, will be a welcome relief for UK businesses and consumers.

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