The Bullish Case For Energy Stocks

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Lower crude oil inventories and less spare capacity among OPEC oil producers are just two of many reasons why I continue to be bullish on energy and energy stocks over the long term.

As I’ve been writing about for months, oil supply remains tight by historical standards. Among the reasons I gave in a post early this summer, I expect crude prices to rebound in the long term: marginal supply is increasingly coming from unconventional higher cost sources, many large oil producing countries require a high crude price to balance their budgets and OPEC has very little spare capacity.

My bullish stance hasn’t changed. Back in early June, the benchmark US crude had traded down from a spring peak of $110 a barrel to a low below $80. Since then crude has rebounded to around $95. Here’s why:

  • OPEC – the large swing producer in global oil markets, has dwindling spare capacity. In May, OPEC’s spare capacity was barely above 11% of production, the lowest level since October of 2008. While spare capacity has rebounded a bit since then, it is still well below the long-term average. This may be a particular problem if tensions escalate in Iran and more Iranian crude is removed from the global market. With less spare capacity it will be more difficult for OPEC to make up the lost production.
  • In addition to less spare capacity, we are also seeing a drop in crude inventories relative to demand. As of the end of July, based on data from the American Petroleum Institute, US inventories had the equivalent of 22.5 days of demand, which is also below the long-term average. As a result, I believe that crude will remain well bid. The major risk to this thesis being either a crisis in Europe or the US going over the fiscal cliff, either of which would likely produce another sharp slowdown in growth and hurt oil demand.

As if that weren’t enough, there’s this handy chart that I blogged about in June, illustrating that global oil demand is likely to greatly outstrip supply by 2030.

How should investors position themselves? In my view, investors should consider maintaining a strategic allocation to a broad commodity benchmark which includes energy. Second, as I’ve advocated in the past, investors should consider an overweight to global energy stocks. Since June 11, 2012, global energy companies have advanced roughly 10%, outperforming a global benchmark by around 3.5 percentage points. Despite the outperformance the sector remains cheap. I continue to advocate an overweight through instruments like the iShares S&P Global Energy Sector Index Fund (NYSEARCA:IXC).

Source: Bloomberg

Disclosure: The author is long IXC.

Disclaimer: International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters.

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