The year 2016 started on a disappointing note with crude prices falling to a 12-year low of $26.21 a barrel in Feb as investors worried about the oversupplied market. The commodity’s collapse threatened the industry’s creditworthiness by hurting cash flows, drying up liquidity and pummeling producer’s profit margins.

However, indications that supply was easing helped oil prices rebound to $50/barrel mark in early Jun. The surge was driven by outages in Nigeria, Libya, Venezuela and Canada – countries that hold some of the world’s major sources of crude. The upward pressure in oil prices also reflected the U.S. Energy Department's inventory releases that showed crude stockpile builds turning into draws. Things were further helped by a continued decline in U.S. crude production.

With factors like Canadian wildfires, Nigerian outages/disruptions, production issues in Venezuela and a strike by Kuwaiti oil workers vanishing from the market, oil slipped back under $40 in the first week of Aug. A glut of refined products also kept the commodity under pressure.

The volatility in oil prices continued with the benchmark touching the $50 threshold again early Oct, buoyed by government figures that continued to show large drawdowns, while investors betted on commitments by Organization of Petroleum Exporting Countries (or OPEC) and non-OPEC players to slash production targets.

When divisions in the cartel became apparent and the future of the ambitious OPEC announcement looked more and more uncertain, the commodity fell back under $45 only to receive a booster shot.

The OPEC Deal:

In a bold but not unexpected move, the OPEC cartel agreed on Nov 30 to reduce production starting next month. Seen as a desperate bid to put a floor on falling oil prices, the group – led by Saudi Arabia – promised to take 1.2 million barrels a day out of the market.

OPEC's decision to cut oil production was not totally surprising though the magnitude of reduction were deeper than many analysts had expected. The move aims to trim output to 32.5 million barrels per day - at the low end of a preliminary agreement struck in Sep.

Russia, which is not part of the body that pumps a third of the world’s oil, will also join output cuts for the first time in 15 years. The biggest supplier outside the bloc relented from its longstanding position of only freezing production and agreed to cut 300,000 barrels from its record high output of more than 10 million barrels a day.

Oil Prices & Stocks Surge:

The OPEC deal had a massive impact on the energy markets, sending crude prices back above $50 a barrel. While the entire sector is roaring higher since the announcement, the independent oil explorers and producers – whose revenues are directly associated with crude price – have been among the best performing stocks. In fact, shares of oil finders like Whiting Petroleum Corp. (WLL), Oasis Petroleum Inc. (OAS) and Marathon Oil Corp. (MRO) exploded higher and climbed to new multi-month highs.

Oil prices rose further, to a 17-month high of $53-a-barrel, after Saudi Arabia surprised markets by signaling that it’s willing to trim output beyond the pledge for the OPEC deal and cut volumes below 10 million barrels per day. To add to the optimism, Russia and several heavyweight non-OPEC countries promised to cut output by 558,000 barrels-a-day.

Certain Factors Still Linger:

Despite OPEC’s success in reaching an output deal, the oil sector is by no means out of the woods.

The commodity is facing the heat on several other fronts. Perhaps most important pertains to the mounting worries about China’s crude demand. In particular, the Asian giant’s currency devaluation has stoked speculation about soft economic growth in the world’s No. 2 energy consumer.  

Energy traders are also fretting over the recent Federal Reserve's decision to raise interest rates for the first time in 12 months. Further, the Fed expected three rate increases next year, higher than the previously projected two rate hikes in September meeting. This statement caught investors by surprise and weighed on markets.

What’s more, the resilience of North American shale suppliers to keep pumping irrespective of prices and concerns over the effects of Brexit on crude demand means that not much upside is expected in prices in the near term. Moreover, a robust dollar has made the greenback-priced crude more expensive for investors holding foreign currency. Stronger focus on cleaner energy and weakness in industrial production worldwide are also holding back oil consumption.

As it is, with inventories near the upper limit of the average range for this time of year, crude is very well stocked and it still looks like the commodity is in an environment of excess supply. Therefore, while the OPEC-driven rally is likely to drive up prices by a few dollars, it certainly can’t be termed as a seismic event.  

Our View:

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bullish trend, mostly trading in the $50-$55 per barrel range. As North American supply remains strong and demand looks underwhelming, oil is likely to maintain its low trajectory throughout at least the first half of 2017.

Natural Gas

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ – natural gas trapped within dense sedimentary rock formations or shale formations – has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or "fracking") – a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves. As a result, once faced with a looming deficit, natural gas is now available in abundance.

Prices Fell to 17-Year Lows Earlier in 2016:

With production from the major shale plays remaining strong and the commodity’s demand failing to keep pace with this supply surge, natural gas prices hit 17-year lows of around $1.6 per million British thermal units (MMBtu) in the first quarter. The glut was further exacerbated by lackluster industrial requirement over the past few years.

And Then Recovered Strongly:

Since then, successive below-average builds on the back of warmer temperature across the country followed by the recent start of the withdrawal season, has been cutting into the year-over-year storage surplus. Statistically speaking, the current storage level – at around 3.8 trillion cubic feet (Tcf) have fallen below last year and is just 5% above the five-year average. As a result, natural gas prices have rebounded strongly and more than doubled from the extreme lows it hit in Mar. The dramatic recovery has helped the commodity stay well above the key psychological level of $3 per MMBtu.

The price strength has translated into major gains for natural gas-weighted firms including the likes of Cimarex Energy Co. (XEC), Southwestern Energy Co. (SWN) and Range Resources Corp. (RRC), which have popped up more than 40% or more year-to-date.

Long-Term Thesis Positive:

With the early winter turning out cooler than expected, natural gas demand has picked up on the back of elevated power sector consumption due to air-conditioning use. Coupled with the easing production from the major shale plays, natural gas prices are set to rise further.

What’s more, rig count is now languishing below 130 – compared to almost 200 a year ago, and the high of 1,606 reached in 2008. Therefore, production growth is unlikely to resume anytime soon.

In general, sentiment toward natural gas is likely to become more positive in the near future as speculators bet on a frigid winter to follow the hot summer.

PLAYING THE SECTOR THROUGH ETFs

Considering the turbulent market dynamics of the energy industry, the safer way to play the volatile yet rewarding sector is through ETFs. In particular, we would advocate tapping the energy scene by targeting the exploration and production (E&P) group.

This sub-sector serves as a pretty good proxy for oil/gas price fluctuations and can act as an excellent investment medium for those who wish to take a long-term exposure within the energy sector. While all oil/gas-related stocks stand to move with fluctuating commodity prices, companies in the E&P sector tend to be the most important, as their product’s values are directly dependent on oil/gas prices. (See all Energy ETFs here)

SPDR S&P Oil & Gas Exploration & Production ETF (XOP Quick QuoteXOP - Free Report) :

Launched in June 19, 2006, XOP is an ETF that seeks investment results corresponding to the S&P Oil & Gas Exploration & Production Select Industry Index. This is an equal-weighted fund consisting of 58 stocks of companies that finds and produces oil and gas, with the top holdings being California Resources Corp. (CRC), Oasis Petroleum Inc. (OAS) and Whiting Petroleum Corp. (WLL). The fund’s expense ratio is 0.35% and pays out a dividend yield of 0.89%. XOP has about $2,506.2 million in assets under management as of Dec 15, 2016.

iShares Dow Jones US Oil & Gas Exploration & Production ETF (IEO Quick QuoteIEO - Free Report) :

This fund began in May 1, 2006 and is based on a free-float adjusted market capitalization-weighted index of 52 stocks focused on exploration and production. The top three holdings are ConocoPhillips (COP), EOG Resources Inc. (EOG) and Phillips 66 (PSX). It charges 0.44% in expense ratio, while the yield is 1.12% as of now. IEO has managed to attract $383.6 million in assets under management till Dec 15, 2016.

PowerShares Dynamic Energy Exploration and Production (PXE Quick QuotePXE - Free Report) :

PXE, launched in October 26, 2005, follows the Energy Exploration & Production Intellidex Index. Comprising of stocks of energy exploration and production companies, PXE is made up of 30 securities. Top holdings include EOG Resources Inc., Anadarko Petroleum Corp. (APC) and Valero Energy Corp. (VLO). The fund’s expense ratio is 0.75% and the dividend yield is 6.49%, while it has got $67.0 million in assets under management as of Dec 15, 2016.

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