Oil stocks have been one of the leaders from the stock market lows in January, accompanied by a 50% surge in crude oil prices.  According to the International Energy Agency (IEA), global oil markets will “move close to balance” in the second half of 2016 as lower prices take their toll on production outside OPEC.  They expect the world surplus will fall to 200,000 barrels a day later this year as production outside of OPEC declines by the most since 1992, due to a reversal in the U.S. shale oil boom.  The glut is also being tempered as Iran restores exports only gradually with financial barriers to sales persisting even after the lifting of international sanctions.

Non-OPEC production expected to drop

The latest outlook represents a shift for the agency, which as recently as February raised its estimates of the global surplus and warned that the potential for further price losses had intensified.  Our own more sceptical view is that the recent surge in prices will actually bring some shale oil production back on line.  Moreover, many of the larger projects continue to move ahead despite higher costs since they still need revenues to pay for the capital costs of the project.  Slowing global economic growth could also limit the expansion in oil demand.  Finally, following the failure of last month’s Doha talks among major oil producers to agree on production freezes, we expect that Saudi Arabia, Iran and Russia will continue to expand their oil production.  In the long run, the Saudis are the low-cost producers and they can survive lower prices better than many of the non-OPEC producers.  Their best strategy is to permanently remove the high cost producers and increase their own market share.  That strategy requires oil prices to stay lower for a longer period of time.  

Back in the world of stocks, another worry we see is that investors continue to borrow at record rates in order to invest.   The chart below shows Margin Debt as a percentage of the total economy (blue line) versus the S&P500 Index (red line).  What we can clearly see is that the last two peaks in Margin Debt occurred at the end of the Tech Bubble (2000) and before the Financial Crisis (2008), both of which preceded major bear markets in stocks.  Investors using borrowed funds tend to be the most aggressive sellers when prices head lower (mostly due to ‘margin calls’ on those funds) and their forced liquidations probably made the bear markets in stocks in 2001 and 2008 worse than they might otherwise have been.  Dial forward to today and we see that margin debt in the U.S. has recently pulled back from a record level of over 2.75% of the economy.  If history is any guide, it does not require any stretch of the imagination to see that we could potentially be heading towards another difficult period for stocks.

Investor borrowing dangerously high?

Not a lot of positive words in this month’s comments, but markets have rallied sharply in the past three months for reasons that are not the basis for longer term gains i.e. improving economic conditions and increasing profits.  While we became more positive in late January when investors seemed excessively bearish and worried, we are now using this strength to reduce exposure to stocks, particularly in the resource sectors.   The Canadian dollar has rallied to the US80c level, but we don’t see this as sustainable and look to stay with U.S. stock holdings in the technology and banking sectors for the better relative returns.   For now, ‘sell in May’ doesn’t seem like a bad strategy!

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