An Exciting Time for the Energy Sector

Oil is back in the news, with the price of benchmark West Texas Intermediate (WTI) crude roughly doubling from last year’s lows driven by steady demand and coordinated supply cuts by Organization of Petroleum Exporting Countries (OPEC) and non-OPEC producers. Energy analysts from across Franklin Templeton’s equity research teams recently had the chance to get together to mull over the state of the market. Fred Fromm, vice president and portfolio manager, Franklin Equity Group, outlines some of their findings.

It’s an exciting time to be an energy investor, and at Franklin Templeton we are finding a number of compelling, bottom-up opportunities across regions, energy subsectors and capital structures.

Our macroeconomic analysis suggests that a moderate crude oil supply deficit will become more evident as the year progresses as a result of declining net imports into the United States and refineries returning from scheduled seasonal maintenance; however, we expect the perceived supply elasticity of US production to cap any material price appreciation in the near term.

The OPEC Effect

Since its founding in 1960, OPEC has played an outsized role in the macroeconomic landscape for crude oil. However, rapid progress in the US shale extraction industry in the 2000s changed global industry dynamics by introducing an elastic source of supply that can respond in a relatively short period of time to price signals in the market. As a result, OPEC members find it more difficult to support higher prices without losing market share, as occurred in the early 1980s.

OPEC’s late-2014 decision, driven by Saudi Arabia, to increase production and avoid a repeat of the debacle in the ‘80s—which took 20 years to alleviate—sent crude oil into a bear market that bottomed in early 2016 when oil slumped below $30 a barrel.

The strategy had its intended effect, gutting the marginal North American producers and causing the US oil rig count to fall from nearly 2,000 at the peak of the cycle to 400 last year.1

However, the impact was not contained within the US market as spending outside the United States also contracted significantly. With OPEC member states also feeling the pain from lower prices, the cartel reversed course in November 2016 and agreed to the first coordinated supply cut in eight years.

Furthermore, OPEC persuaded 11 state producers outside of the cartel, including Russia, to voluntarily cut production. These actions, when viewed against a backdrop of relatively stable demand growth, have supported the price recovery to today’s levels.