Weekly Trends February 19, 2016

7/26/2019 Weekly Trends February 19, 2016

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Weekly TrendsRyan Lewenza, CFA, CMT, Private Client Strategist February 19, 2016

Please read domestic and foreign disclosure/risk information beginning on page 5

Raymond James Ltd. 5300-40 King St W. | Toronto ON Canada M5H 3Y2.

2200-925 West Georgia Street | Vancouver BC Canada V6C 3L2.

Oil….When Will It Bottom?

The WTI oil price has declined a staggering 75% since June 2014, essentiallymatching the 77% decline in 2008. An important contributing factor to the

decline in oil prices is the sizable increase in US oil production over the last few

years. This increased US production, along with record production by OPEC, has

led to an oversupply of roughly 1.5 to 2 mln bpd in the global oil markets.

To bring the global oil markets back into balance, either demand will have to

increase, or supply will have to be cut. Given our modest global growth

expectations, we don’t see demand increasing meaningfully from here.

Therefore, that leaves production cuts to help bring the global oil markets back

into equilibrium. We are seeing early signs of this.

In the US, total daily oil production is down 400,000 bbl from the peak of 9.6

mln bpd last summer. We expect this to continue in the coming months, with US

oil production possibly declining below 9 mln bpd.

More importantly, the tone from OPEC producers and Russia has changed and

they are now beginning to discuss the prospect of production cuts. This week we

saw further evidence of this with OPEC officials meeting with Iran to discuss a

“production freeze”. Initially Iran rejected the freeze, however, following the

meeting, Iran did in fact agree, which we believe could be the first steps to a

future production cut.

We believe we are seeing early signs of producers addressing the oversupply in

the oil markets, and believe that WTI will rebound later this year. This view is

echoed by our US energy analyst, Pavel Molchanov, who is predicting that “oil

prices should bottom in the first half (probably Q1/16), and rise substantially in

the back half, averaging US$50 WTI for the year.”

Equity Market YTD Returns (%)

Canadian Sectors Weight Recommendation

Consumer Discretionary 6.7 Market weight

Consumer Staples 4.7 Market weight

Ener gy 1 8.3 Ma rket wei ght

Fi na nc ia ls 3 8.1 Ma rket wei ght

Health Care 3.0 Market weight

Industrials 8.0 Overweight

Technol ogy 3.2 Overwei ght

Materials 9.5 Underweight

Communications 5.9 Overweight

Uti liti es 2.5 Underwei ght

Technical Considerations Level Reading

S&P/TSX Compos ite 12,778.6

50-DMA 12,638.6 Uptrend

200-DMA 13,754.2 Downtrend

RSI (14-day) 58.8 Neutral

Source: Bloomberg, Raymond James Ltd.

Sectors are based on Bloomberg classifications

-6.0

-8.6

-10.0

-7.2

-11.5

-6.5

-1.4

-1.8

-15 -10 -5 0

MSCI EM

MSCI EAFE

MSCI Europe

MSCI World

Russell 2000

S&P 500

S&P/TSX Small Cap

S&P/TSX Comp

11,000

11,500

12,000

12,500

13,000

13,500

14,000

14,500

15,000

15,500

16,000

S&P/TSX

50-DMA

200-DMA

Chart of the Week

History Suggests A Bottom In The Energy Sector This Year


TSX Energy Bear Markets

Peak Date Duration (Mths) Decline %

Aug-81 12 -54%

Dec-85 15 -34%

Sep-90 18 -35%

Oct-97 17 -51%

Jun-08 9 -59%

Jun-14 18 -46%

Average 15 -47%Median 16 -49%



Weekly Trends February 19, 2016 | of 5

Oil….When Will It Bottom?

The WTI oil price has declined a staggering 75% since June 2014, essentially matching

the 77% decline in 2008. Think about that for a moment. Oil prices are down a

similar amount to 2008, when the global economy was experiencing its deepest

contraction in decades, and was on the precipice of a global depression! In this

week’s publication we discuss how we got here, and provide our outlook for oilprices.

Let’s first provide the background on why prices have fallen so dramatically. The

precipitous decline in global oil prices can be traced back to major technological

advancements in the oil and gas industry that have created new ways to extract oil

from the ground. In particular, hydraulic fracking and horizontal drilling have been

game changers for the oil and gas industry. Hydraulic fracking involves the high

pressure injection of fluids into the ground to release gas or oil found in rock

formations. Horizontal drilling is a process in which the well is turned horizontally,

rather than the typical vertical drilling well. These two drilling methods were first

used in natural gas exploration, but were then modified to be used for oil

production. These new drilling techniques, which were pioneered by US producers,

have had an enormous impact on US oil production. US oil production had been on asteady decline for decades, declining from roughly 7 mln bpd in the early 1990s to

roughly 5 mln bpd in the early 2010s. This all changed around 2011, as US oil shale

production ramped up from roughly 1.5 mln bpd to a peak of 5.5 mln bpd in 2015.

This dramatic rise in US shale production caused total US oil production to rise from

roughly 5 mln bpd in 2011 to a peak of 9.6 mln bpd in mid-2015. This near doubling

of US oil production had a material impact on global oil production, and led to a

decline in market share of OPEC producers, such as Saudi Arabia.

Despite this dramatic increase in US oil production, OPEC and other non-OPEC

countries (e.g., Russia) continued to pump out oil at record levels which has led to the

current oversupply in the global oil markets. According to the International Energy

Agency (IEA), the global oil markets went from a shortage of 1.8 mln bpd in Q3/11, to

an oversupply of roughly 1.5 mln bpd in 2015. Historically, OPEC would cut productionwhen supply had significantly outstripped demand. However, this time they decided

to maintain their production limits, to purposely drive prices lower, in an effort to

drive out US shale producers and recapture their lost market share. Well, mission

accomplished, as oil prices have fallen far further than most expected, and it ’s why

we’re in this predicament today.

US Oil Production Has Doubled In Just A Few Years Which Has Contributed To The Current Oversupply


3000

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9000

10000

'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

US Crude Oil Total Production

(1,000/day)

-3

-2

-1

0

1

2

3

4

'94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Daily Global Oil Oversupply/Shortage (mls bpd)

Oversupply

Shortage




What We Are Looking For In A Bottom

As discussed, the problem with oil prices is not demand, which rose to a record high

in 2015 (95.4 mln bpd in Q3/15), but rather a clear oversupply of oil. To bring the

global oil markets back into balance, either demand will have to increase, or supply

will have to be cut. Given our modest global growth expectations, we don’t see

demand increasing meaningfully from here. Therefore, that leaves production cutsto help bring the global oil markets back into equilibrium. We are seeing early signs

of this.

With the depressed oil price, the number of global oil rigs has fallen dramatically

over the last few years. In the US, rig count has declined from a peak of 1,600 in

2014 to 439 today and in Canada from roughly 600 to 220 today. Moreover, US$200

billion has been slashed from global energy capital budgets in 2015, according to

Bloomberg. Given the combination of declining oil rigs, and the large cuts to capital

spending by oil and gas companies, it is just a matter of time before we start to see

more meaningful declines in oil production. In the US we’ve already seen this with

total daily oil production down 400,000 bbl from the peak of 9.6 mln bpd last

summer. We expect this to continue in the coming months, with US oil production

possibly declining below 9 mln bpd. In total, we expect more than a half a millionbarrels of US oil to come out of the market, helping to address the estimated 1.5 to 2

mln bpd of oversupply.

More importantly, the tone from OPEC producers and Russia has changed and they

are now beginning to discuss the prospect of production cuts. Combined, these two

producers account for roughly 40 mln bpd or 42% of total daily oil supply. While the

lower US oil production will help, it is crucial that OPEC and Russia cut production for

global oil markets to find equilibrium.

This week we saw further evidence of OPEC producers being more open to potential

cuts, with OPEC officials meeting with Iran to discuss a “production freeze”. Initially

Iran said they would not be open to a production freeze since: 1) Iran’s sanctions

have just been removed, allowing them to now sell their oil to western markets; and

2) they were not the cause of the major drop in oil prices so why should they agree

to a production freeze. However, following the meeting, Iran did in fact agree, which

we believe could be the first step to potential future production cuts. While far from

a certainty, we continue to believe there is chance of an OPEC cut in the coming

months, which if it were to happen, would be bullish for oil prices and likely mark the

bottom in this oil bear market.

US Oil Rig Count Is Down By 2/3 OPEC/Russia Production Remains At Peak Levels


0

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'00 '02 '04 '06 '08 '10 '12 '14 '16

Baker Hughes US Oil Rig Count

8500

9000

9500

10000

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11000

24000

25000

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27000

28000

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3000031000

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'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

OPEC Oil Production (LHS)

Russia Oil Production (RHS)

(1,000/day)




Signals On When To Buy

We believe we are seeing early signs of producers addressing the oversupply in the

oil markets, and believe that WTI will rebound later this year, as the oversupply is

reduced. This view is echoed by our US energy analyst, Pavel Molchanov, who is

predicting that “oil prices should bottom in the first half (probably Q1/16), and rise

substantially in the back half, averaging US$50 WTI for the year.” If correct, then weshould be looking at increasing exposure to the beaten down sector. Below are the

signals that we are monitoring to spot a change in trend, and begin adding to the

sector:

Inventories: US oil inventories continue to build which is weighing on the

WTI oil price. This week US crude inventories rose by 2.1 mln bbl to 504.1

mln, a new record high. We are monitoring the Y/Y change in inventories,

which we believe is more important than the level of inventories. On a Y/Y

basis, US inventory growth peaked at 30% in December 2015. If this Y/Y

change continues to decline this could help to put in a bottom in prices.

Revisions: Earnings for the energy sector continue to be revised lower.

We’re watching revisions closely, and if they can bottom and begin to hookup, this may confirm the worst is behind us.

Technicals: Finally, given our multi-disciplined investment approach, we are

watching the technicals closely for the S&P/TSX Capped Energy Index. If the

index can break above the 160 level, this would end the multi-year

downtrend, and would likely cause us to increase exposure to the sector.

So there you have it. We believe the oil markets are in the process of addressing the

oversupply, which should result in bottom some time this year, with prices

rebounding in H2/16. We’ve had the sector at a market weight for some time, but

will likely upgrade the sector to overweight once we have confidence the low is in for

WTI, and the S&P/TSX energy sector breaks above its long-term downtrend.

US Crude Inventories Y/Y Change S&P/TSX Capped Energy Index Technical Profile


-20%

-10%

0%

10%

20%

30%

40%

'00 '02 '04 '06 '08 '10 '12 '14 '16

Weekly US Crude Oil Stock excluding SPR Y/Y Chg




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Weekly Trends February 19, 2016

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