The emerging positive narrative of a favorable outlook for the U.S. economy has done wonders for the markets, particularly equities and commodities. The broad equity markets as well as most commodity groups are up smartly from their early-March lows.
Crude oil's gains have been even more impressive, given its heavy leverage to the health of the global economy. Our view is that oil should be able to hold onto its recent gains and consolidate around current levels, provided this favorable economic view remains in place.
While we have greater confidence in the staying power of the current oil rally, this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2010 to be higher than the 2009 levels, but remain significantly below the 2008 peak levels.
Crude oil's near-term fundamentals remain dismal, to say the least. Inventories in the U.S. are at 18-year highs and remain bloated worldwide. Demand remains anemic and projections continue to come down. At current projections, global 2009 demand will be below last year's level, which itself was below the 2007 level -- the first time since the early 1980's of two back-to-back negative growth years.
The only positive in this otherwise bleak supply-demand picture is OPEC's success at taking a fair amount of oil off the market. OPEC's successful stewardship provided the commodity with a floor in Dec'08 in the low $30's a barrel range.
While the market has been heavily discounting the commodity's near-term problems, we would expect the day-to-day price movement to largely track the news flow about the health of the global economy.
The oil price outlook has historically been the key determinant of the sector's performance. And given our favorable oil price view, we would strongly advocate for taking an over-weight position in the sector.
OPPORTUNITIES
This outlook has major implications for sub-sector choices within the energy space, though the risk-reward trade off for most of these sub-sectors remains compelling despite recent gains.
Historically, the large-cap integrateds would outperform in a down trending oil price environment, owing to their low-beta and defensive postures. We saw that with Exxon's (XOM) stellar performance in the face of market meltdown last fall.
But these stocks lag in a consolidating and/or rising oil price market, as we have seen in the recent past. To better capitalize on this outlook, we would advocate a growing exposure to the large-cap service names such as Schlumberger (SLB) and deepwater drillers such as Diamond Offshore (DO). Other service names, such as Ensco International (ESV) and Weatherford (WFT) provide ample early-cycle leverage.
WEAKNESSES
Despite their strong recent gains, we continue to feel strongly that industry players in the servicing and drilling ends of the business with substantial natural gas-focused and North America-centric operations should be avoided.
The two major sub-sectors that fit that description would be the onshore drillers and service players with heavy pressure pumping operations. We believe that pricing and margins for operators in these two sub-sectors will remain under pressure through 2010, even as the outlook for natural gas price improves.
Halliburton (HAL), the largest North American pressure pumping player, and BJ Services (BJS), one the largest in this category, need to be avoided. We also have Sell recommendations for Nabors (NBR) and Patterson-UTI (PTEN), two major North American land drillers.
