Are things looking up for the oil industry? After years of struggling with low prices, oil companies got a boost on Nov. 30, after the 14 members of the Organization of the Petroleum Exporting Countries (OPEC) and other major oil exporters formally agreed to scale back production. Markets jumped on the news: WTI (West Texas Intermediate Crude) oil prices surged to around $50 a barrel from recent lows of around $40, and gains in U.S.-listed oil stocks helped the S&P 500® Index touch record highs.
The market also seemed more optimistic about where prices might head in the coming weeks, as one measure of expected future oil price volatility plunged after the agreement was announced.1 It had risen sharply over the previous month as some OPEC members seemed to waver in their commitment to production cuts.
So, does the deal portend a durable rise in prices and a new era of profits for oil companies? Is now the time to buy energy stocks? Not necessarily.
“I suspect this move in oil is probably temporary and may not last very long, even though it is giving a boost to the market,” says Randy Frederick, vice president of trading and derivatives at Charles Schwab & Co., Inc.
Here we’ll discuss the oil market and some factors that could keep prices in check.
A quick look back
The oil industry is hoping for a reversal after years of low prices. In mid-2008, oil traded at roughly $150 a barrel. Then came the demand-crushing financial crisis and a supply glut, which left oil trading for less than $30 a barrel as recently as February 2016.
The supply glut was partly OPEC’s own doing. The growth of hydraulic fracturing, or “fracking,” has made the U.S. one of the world’s leading oil producers. In a bid to protect their market share, OPEC countries ramped up production in 2014, driving down prices with a goal of pushing U.S. companies out of the market. Eventually, those low prices started to hurt oil producers across the board.
OPEC countries pump about 40% of the world’s crude oil, but they punch well above their weight when it comes to trade: OPEC exports account for about 60% of oil traded globally, according to the U.S. Energy Information Administration. That’s why word that OPEC agreed to cut output by 1.2 million barrels a day—or about 1% of total global production—sent prices up. Major non-OPEC producers including Russia also agreed to cuts.
However, there are a few reasons to be skeptical that prices are destined to surge in the months ahead.
- It could take a while for the effects of the cuts to appear. OPEC’s agreement will take effect in January, but inventories across the globe are still growing, meaning it could still take time to run down the supply glut.
- OPEC hasn’t always been able to stick to its production agreements. Each member of the organization has its own priorities and relies to a different degree on revenue from oil exports. Under the latest agreement, Saudi Arabia has agreed to accept the biggest cuts, while Nigeria and Libya were exempted from making any cuts and Iran will actually be allowed to increase production. In the past, differences between member countries made it difficult for OPEC to stick to its production agreements. Rising prices could prove a tempting excuse to boost production again. And Russia could always back away from its own plans to cut output.
- U.S. producers can get their rigs pumping pretty quickly. If oil prices do start rising, producers in the U.S. could ramp up their own production, and that extra supply coming online could keep prices in check.
- A stronger dollar could weigh on prices. Crude oil is priced in dollars, and when the dollar rises, the price of oil tends to fall in response. A stronger dollar can also make oil more expensive overseas, hurting global demand. That matters because the Federal Reserve looks set to raise interest rates at its meeting in mid-December, and tighter monetary conditions could push the dollar up against other currencies. Meanwhile, the incoming administration of President-elect Donald Trump has promised an array of policies that could spur economic growth and inflation, raising the possibility of more rate hikes in the future.
All things considered, we think oil prices could face enough headwinds that they could struggle to rise much above $50 per barrel in the coming months. It’s also worth noting that energy stocks have already had a pretty good run so far this year. The S&P 500 Energy Index has delivered year-to-date total returns of nearly 22%.2
So now might not be the time to increase your exposure to the energy sector. Though, you shouldn’t avoid it either. After all, stronger growth in the U.S. or China could boost demand, and geopolitical tensions could always hamper trade, which would support oil prices.
Rather, it may make more sense to focus on making sure your allocation is in-line with your long-term goals and risk tolerance.
1Based on the CBOE Crude Oil Volatility Index, data as of 11/30/2016.
2Data as 11/30/2016.