Supply And Demand Driving Crude Oil Fluctuations

Brian Selzer

OCEAN CITY — We recently upgraded our commodity outlook to neutral from negative, as the steep decline in prices should help spur economic growth in the medium term, and with it demand for natural resources.

However, headwinds may persist given a stronger U.S. dollar, rising interest rates and growing supply. With regard to oil, we expect prices to stay lower for longer, recovering only slowly over the next 12 to 18 months. However, with broad declines in equity prices across the Energy sector, we believe there is adequate scope to rebalance and select opportunities for more tactically-oriented investors.

Oil prices have remained volatile in the last few weeks. Following a modest rebound in February, West Texas Intermediate (WTI) crude touched a new low of $42 per barrel last week. This range-bound trading is indicative of a market seeking a new equilibrium as demand seems unable to catch up to a surge in supply. This has contributed to growth in crude inventories to the highest level since the Energy Information Administration (EIA) began tracking them weekly in 1982. In fact, monthly stockpiles have not been this high since 1931. The price of Brent crude, extracted from Europe’s North Sea, is holding up better, resulting in a widening differential of nearly $10 per barrel.

We believe headwinds from the macroeconomic environment may persist. Slowing demand from China and other Emerging Markets and a strengthening U.S. dollar could keep downward pressure on oil prices for some time. BofA Merrill Lynch (BofAML) Global Commodity Research strategist Francisco Blanch expects oil prices to decline over the next few months but gradually recover towards year-end – his targets are $57 per barrel for WTI and $61 per barrel for Brent.

Doug Leggate, the head of U.S. Oil and Gas Equity Research at BofAML Global Research, sees growing demand from refiners as they come back on line from seasonal shutdowns. This should help reduce crude oil inventories and put more refined products in the market, keeping gasoline prices low for consumers.

Last week, daily U.S. production of crude oil rose to 9.4 million barrels, the highest level in three decades; even as the rig count dropped by roughly 50% since mid-October. However, Leggate believes that a production slowdown will follow, with U.S. shale output peaking this month and then falling 400,000 barrels per day by year-end.

The oil market dislocations have caused broad stock price declines across the Energy sector, creating opportunities for patient investors to rebalance their exposure.

Over the medium term, oil producers with low and flexible cost structures should be able to weather lower prices. High-quality companies with strong balance sheets and solid cash flows should also hold up relatively well. These groups might also benefit from an industry shakeout by acquiring assets of weaker players.

The oversupply of oil should increase the need for pipeline and storage infrastructure, which should benefit energy Master Limited Partnerships as an asset class. A large part of the investment thesis for MLPs is their favorable tax status, attractive dividend yield and growth of cash distributions. These characteristics make them attractive for income-seeking investors, positioning them to benefit from the global hunt for yield while providing a certain degree of immunity to rising rates.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

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