Weekly Trends

Ryan Lewenza, CFA, CMT, Private Client Strategist

February 19, 2016

Oil.When Will It Bottom?

Equity Market YTD Returns (%)

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

S&P/TSX Comp

-1.8

S&P/TSX Small Cap

-1.4

S&P 500

-6.5

Russell 2000

-11.5

MSCI World

-7.2

MSCI Europe

-10.0

MSCI EAFE

-8.6

MSCI EM

-6.0
-15

-5

Weight

Recommendation

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.

Consumer Discretionary

6.7

Market weight

Consumer Staples

4.7

Market weight

Energy

18.3

Market weight

Financials

38.1

Market weight

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.

Health Care

3.0

Market weight

Industrials

8.0

Overweight

Technology

3.2

Overweight

Materials

9.5

Underweight

Communications

5.9

Overweight

Utilities

2.5

Underweight

Level

Reading

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.

Canadian Sectors

-10

Technical Considerations
S&P/TSX Composite

12,778.6

50-DMA

12,638.6

Uptrend

200-DMA

13,754.2

Downtrend

58.8

Neutral

RSI (14-day)
16,000
15,500

Chart of the Week

15,000

History Suggests A Bottom In The Energy Sector This Year

14,000

TSX Energy Bear Markets

Peak Date
Aug-81
Dec-85
Sep-90
Oct-97
Jun-08
Jun-14
Average
Median

14,500
13,500

Duration (Mths)
12
15
18
17
9
18
15
16

Decline %
-54%
-34%
-35%
-51%
-59%
-46%
-47%
-49%

Source: Bloomberg, Raymond James Ltd.

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.

13,000
12,500
12,000
11,500
11,000

S&P/TSX
50-DMA
200-DMA

Source: Bloomberg, Raymond James Ltd.

Sectors are based on Bloomberg classifications

Weekly Trends

February 19, 2016 | Page 2 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
weeks publication we discuss how we got here, and provide our outlook for oil
prices.
Lets 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 a
steady 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 production
when 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 its why
were in this predicament today.
US Oil Production Has Doubled In Just A Few Years

Which Has Contributed To The Current Oversupply

4

(1,000/day)

Daily Global Oil Oversupply/Shortage (mls bpd)

10000
3

9000

Oversupply

8000

7000
6000

5000

-1

4000

-2

US Crude Oil Total Production

Shortage

3000
'90

'92

'94

'96

'98

'00

'02

Source: Bloomberg, Raymond James Ltd.

'04

'06

'08

'10

'12

'14

-3
'94

'96

'98

'00

'02

'04

'06

'08

'10

'12

'14

Weekly Trends

February 19, 2016 | Page 3 of 5

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 dont 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.
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 weve 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 million
barrels 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) Irans 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

1800

(1,000/day)

Baker Hughes US Oil Rig Count

1600

34000

11000

33000

1400

32000

1200

10500

31000

1000

30000

800

29000

600

28000

10000
9500

27000

400

26000

200

OPEC Oil Production (LHS)

25000

Russia Oil Production (RHS)

24000

'00

'02

'04

'06

'08

Source: Bloomberg, Raymond James Ltd.

'10

'12

'14

'16

9000

8500
'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

Weekly Trends

February 19, 2016 | Page 4 of 5

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 we
should 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.
Were watching revisions closely, and if they can bottom and begin to hook
up, 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. Weve 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

40%
Weekly US Crude Oil Stock excluding SPR Y/Y Chg

30%
20%
10%
0%
-10%
-20%
'00

'02

'04

'06

'08

Source: Bloomberg, Raymond James Ltd.

'10

'12

'14

'16

Weekly Trends

February 19, 2016 | Page 5 of 5

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