As the Calgary Stampede kicks off this week, there remains a subdued optimism that the bear that has overrun the oilpatch during the past two years will soon turn back into a bull.
While it helps that oil has rebounded back to near $50 a barrel from its $26 low in January, when looking ahead we think the oil and gas cowboys may soon realize that they have simply exchanged the behemoth grizzly they were riding for a smaller but still hungry black bear.
In particular, we see five major headwinds that could prevent the return of a bull market, at least in the near-term.
A rising U.S. dollar
We maintain our view that the recent Brexit result, while having little to no impact on current demand, is a longer-term positive for oil when factoring in the continued undersupply of capital to what is perceived as a very risky sector.
However, there remains nearer-term downside pressure to U.S. dollar denominated commodities as global investors go risk-off and continue to chase higher yielding U.S. debt, thereby pushing the dollar higher and oil prices lower.
The Brexit vote created a tremendous amount of fear, increasing the demand for bonds and pushing yields to record lows. According to a recent Fitch report, there is now a whopping $11.7 trillion of global negative-yielding debt, a material 12.5 per cent gain from the end of May. Of this, $2.6 trillion has a maturity longer than seven years, nearly double the amount in April.
This has also caused global investors to pile into higher yielding 30-year U.S. Treasuries, sending them up approximately seven per cent last month and the yield down to a paltry 2.16 per cent. Not surprisingly, the U.S. dollar has responded in kind, already recouping half of this year's losses.
While the rise in the dollar combined with the uncertainty around the Brexit will likely push off the chance of a Fed rate hike until next year at the earliest, we worry that this may not be enough to offset the current flood into higher yielding U.S. debt and subsequently the U.S. dollar.
Weakening emerging market demand
According to JP Morgan, China has been stockpiling oil to the tune of approximately 1.2 million barrels per day so far this year, pushing its strategic petroleum reserve to an estimated 400 million barrels. The problem is what happens when they reach the estimated 511 million barrel capacity in roughly three months' time and remove this incremental demand from the market.
Outages are coming back online
There were an estimated 3.6 million barrels per day of global supply outages as of May 2016, according to the U.S. Energy Information Administration. Of this, roughly one million barrels per day of curtailed oil production from Canada and Nigeria has already starting to come back online.
U.S. refinery runs, which are a strong source of demand for crude oil, have been very robust this year posting a nice rebound from their February lows. That said, time is running out fast with only one to two more months of peak season demand and refineries beginning to prepare for the fall turnaround season. To add some perspective on the potential magnitude, last year U.S. refinery runs fell 1.8 million barrels per day from their peak in August through to the lows in October, according to National Bank's commodity group.
On a broader level, there has been a noticeable seasonality to the oil price over the past two years, which as a caveat, does not necessarily mean it will repeat itself but there is a chance it could rhyme.
Potential for a disappointing production response in the U.S.
Finally, all eyes are on U.S shale producers, looking for the impact from the capital reductions. Specifically, oil production has fallen by an estimated 950,000 barrels per day since its April 2015 peak thanks to a rig count that has collapsed from over 1,600 to only 341.
The problem looking ahead is in the Gulf of Mexico where, there are more than 500,000 barrels per day set to come online from tie-back wells within the next 12 months, according to a Wall Street Journal report. The report cites EIA data showing that U.S. offshore oil production remains on track to grow to a record 1.91 million barrels per day by the of the year.
In conclusion, our contrarian nature has us skittish here around the near-term outlook for both oil prices and oil stocks especially given the materiality of some of the current risks. Plus we prefer to get off the ride whenever there is a risk of becoming a pancake breakfast.