Oil - Paving The Road To Recovery

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: AllianceBernstein (AB)

By Vinod Chathlani

Oil began its calamitous slide in mid-2014, and there's been a lot of speculation since then about when -- and how quickly -- it will recover. By analyzing past oil cycles and their drivers, we can understand what the signs of a sustainable rally might be.

Learning Lessons from Oil's Past

Since 1985, there have been six oil crashes where the spot price has fallen by more than 20%, measured from peak to trough. But not all oil sell-offs are the same: the underlying drivers and macro environment, the path of recovery, oil's correlation with risk assets, and optimal portfolio exposures can vary.

But we can draw some conclusions from analyzing oil's history. Sell-offs generally last longer if they are dominated by supply shocks rather than demand shocks. Oil has also had a low correlation to risk assets in these supply-shock sell-offs, and they're a net positive for subsequent global GDP growth.

Regardless of the specific drivers of troughs and their later recoveries in oil markets, the turning points in these cycles generally have had three signs in common:

1. Investor sentiment and positioning turns positive. When a recovery is at hand, investors' attitudes and actions usually reflect it. The volatility of oil-futures contracts declines, speculators' positioning begins to favor long exposures, and oil's spot price gains momentum.

2. The oil-futures curve flattens. When "prompt"-or the closest expiring-oil-futures prices are lower than prices further out, that tends to indicate near-term oversupply concerns and/or a buildup of oil inventory (assuming there's an upward-sloping curve, or "contango," with the prices of longer-term futures higher than those of shorter-term futures; the opposite of this is known as "backwardation"). As investors become more confident that fundamentals are improving (e.g., they expect inventory buildup to slow), the curve tends to flatten.

3. Inventory buildups slow/an inventory drawdown starts. When actual oil inventory declines, or even when it builds up less slowly, that can indicate that oil-supply growth is slowing or that demand is improving. This can suggest a turning point in the oil cycle.

Oil's Current Episode: Largely Supply Driven

Supply factors were the main drivers of the current oil sell-off (2014-16), as OPEC shifted its policy in response to growing U.S. shale-oil supply in an environment of fairly robust demand. The sell-off was intensified by a strong U.S. dollar and a lower-than-expected impact from potential geopolitical risks.

Oil's correlation to risk assets has been low this time around, which is consistent with past supply cycles. But this cycle appears to differ in one respect: Stress on commodity producers has surfaced quickly, but the benefit to other parts of the global economy has been more subtle and hasn't materialized completely yet because of a backdrop of anemic pricing power.

Nevertheless, we believe that the trough and recovery signals above would be effective at indicating a turn in the oil cycle. At this point, investor sentiment and positioning has turned positive, and the oil-futures yield curve has flattened since February (Display 1).

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But we haven't seen the third signal yet. There have been no reliable signs of an inventory slowdown -- either actual or forecast (Display 2). If we saw a consistently positive reading of a slowdown in inventory buildups, that would provide the third piece of evidence that a much-awaited medium-term bull market in oil has arrived.

Click to enlarge

Where Do Investors Go From Here?

We think we've seen the bottom in oil prices for this cycle. But prices are moving materially right now based on very little fundamental data, which is slowing the recovery process.

From an investment perspective, we think a modest overweight to energy through a combination of assets such as consumer price index swaps, energy-sector equities, commodity futures and commodity currencies could be an effective strategy for investors. But it takes research and careful analysis to identify the specific investments that will provide the best balance of risk and return potential.