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Oil Prices Make A Tentative Recovery

U.S. oil prices were back above $50/barrel for the first time in three weeks after rallying 4 percent on the back of better-than-expe-

cted U.S. inventory data, supply outages in Libya and Nigeria, and talk about a possible extension of the OPEC deal. Several

OPEC members, including Kuwait, have voiced support for an extension to the current six-month production cut.

Many analysts, however, remain unconvinced that the rally will run for much longer.

Oil prices took a beating in early March due to a buildup in U.S. inventories, reversing a nice recovery from November 2016 lows

following an agreement by OPEC members to limit production for six months starting 2017. OPEC, which accounts for about 40

percent of the world’s oil output, agreed to cut production by 1.2 million barrels per day (bpd) while other oil-producing nations

including Russia agreed to lower production by another 550,000 million barrels.

Source: Nasdaq

While those cuts look relatively small compared to a global market of 96 million bpd, they have so far proven to be quite effective

at controlling swelling inventories and goosing prices. According to the IEA, OPEC has averaged an impressive cut compliance

rate of 98%, largely helped by Saudi Arabia which has upped its cut to 135% of its pledge.

But resurgent U.S. production might nullify at least part of those gains, and put downward pressure on oil prices. U.S. shale

production is expected to rise by 109,000 bpd in April to hit 4.96 million bpd, representing the biggest monthly increase since

October 2016. According to data by Baker Hughes, the number of active U.S. oil drilling rigs has increased for 11 straight weeks

while production has consistently been rising since mid-2016.

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Source: Seeking Alpha

U.S. oil production reached its most recent peak in the summer of 2015 at

9.6 million bpd. Production then slid for 12 straight months before bottoming

out at 8.4 million bpd. And now the country’s production looks set to continue

increasing. President Donald Trump has promised to ease regulation in the

energy sector and actively encourage more production. He recently signed

an executive order that will effectively roll back Obama’s Clean Power rule

and carbon restrictions thus allowing for increased oil and coal production.

Energy research firm IHS energy estimates that U.S. oil producers will add

another 600,000 bpd by the end of the year.

The tug-of-war between the OPEC and the U.S. will not be helped by recalci-

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trant nations that have failed to stick to their pledges. Russia, the biggest non-OPEC oil producer accounting for half of non-OPEC

production, has only implemented about one third of its pledged reduction. Non-OPEC members have only cut production by

37% of their commitment.

U.S. oil and product inventories falling

It’s encouraging though to note combined crude oil and oil product inventories in the U.S. have lately been ticking lower despite

increasing production. Oil inventories are currently sitting at a record 533.9 million barrels but aggregate inventories have fallen by

23.5 million barrels from their peak in early February. This obviously bodes well for the future of oil prices.

Source: FuelFix

Product inventories have been falling at a nice clip, and recently DOE reported that inventories declined by 6.2 million barrels last

week. Product inventories have declined by a cumulative 36.5 million barrels over the past six weeks, the biggest six-week decline

in almost 11 years. U.S. summer driving season is quickly approaching and product inventories are likely to slide even further.

Crack spreads have been widening, a trend that is likely to incentivize refineries to purchase more crude which in turn is likely

to drive prices higher. Crack spreads is a market proxy for the profit margins that refineries receive. Gasoline crack spreads is

considered a leading indicator of crude prices as we head to the summer driving season. Gasoline crack spreads have widened

to levels last seen in early 2016.

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Source: Bloomberg

The long-term outlook on oil prices might hinge strongly on how quickly the U.S. increases domestic output, and whether non-

OPEC members will improve compliance. The short- and medium-term outlook though looks good. According to the IEA, if

current production levels are maintained through June when the current OPEC output deal expires, there will be a deficit of 0.5

MMBOPD in the market during the first half of 2017. That might prove enough to at least prevent another sharp downturn in prices.

Source: EIA

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Major oil ETFs have remained in the red in the year-to-date--PowerShare DB Energy Fund (DBE) is down 9.4% YTD while

United States Gasoline Fund (UGA) is 13.3% lower over the timeframe.

Patient investors might be rewarded if they open new positions now. Oil ETFs have been showing positive price action over the

past few days due to the uptick in crude prices.

PowerShare DB Energy Fund (DBE) 5-Day Returns

United States Gasoline Fund (UGA) 5-Day Returns

Source: CNN Money

Trump Trade faces major tests in March

Stock markets came under pressure in March after the central bank raised federal funds target rate by 25 basis points to 0.75-

1.0 percent, only the third since the financial crisis, and signaled two more hikes to come in the current year. Stocks were tested

again after House Republican leaders pulled a rewrite of the Affordable Care Act, better known as Obamacare, from consideration

after the president failed to rally enough support from his Republican party to repeal and replace Obamacare. The House health

bill aimed to cancel a penalty against people who fail to buy coverage, lower Medicaid spending, and rescind taxes created by

Obamacare.

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The developments seemed to temporarily halt the famous Trump Trade. Markets suffered heavy selling pressure immediately after

the healthcare defeat-- the Dow was left nursing triple-digit losses of 170 points while the S&P 500 and Nasdaq opened 20.3 and

53.7 points lower, respectively, on Monday trading. That marked the worst one-day drop by the markets in five months.

S&P 500 Index (SPX) 30-Day Returns

Dow Jones Industrial Average (DJIA) 30-Day Returns

NASDAQ Composite Index (COMP) 30-Day Returns

Source: CNN Money

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Yet stocks recovered almost immediately thereafter, an indication that the market does not believe that the Republican gridlock

threatens other important legislation, particularly regarding tax reform and increased infrastructure spending. House speaker

Ryan and Trump are both in agreement about tax cuts that call for paring back personal income tax brackets from the current

seven to three, lowering top individual tax rate from 39.6 to 33 percent and trimming corporate tax from 35 to 15-20 percent.

Lower corporate tax is likely to entice American corporations to repatriate at least some of the $2 trillion cash they have parked

in overseas accounts.

Meanwhile, Trump has proposed to spend at least $1 trillion on improving infrastructure. That level of spending is likely to have a

nice ripple effect on multiple sectors of the economy.

There’s a risk to the bullishness though since passing new tax legislation might not be as smooth-sailing as many investors may

wish. Treasury secretary Steve Mnuchin has said that the administration is looking to enact the new tax plan before Congress

goes on recess in August. But if history is any guide, this might not be achievable. The last fully fledged economic reform of 1986

took more than 12 months to complete. Further, Mr. Trump has already expressed skepticism about the proposed border tax that

intends to tax imports but zero-rate exports. This is likely to create another snag during congressional negotiations.

Economy remains on solid ground

Although the revised fourth-quarter 2016 U.S. GDP growth of 2.1% vs. 1.9% previous estimate falls far short of Trump’s long-term

target of 4%, it’s still a considerable improvement compared to 1.6% growth for the whole of 2016.

Robust consumer spending has been particularly encouraging. Excluding gasoline, retail sales are expected to climb a healthy

4.2% in 2017, better than the 3.8% growth recorded in 2016. Core retail spending jumped 0.9% year-over-year before slowing

to a more modest 0.1% in February. Although motor vehicles sales dropped in both months, the fall came on the back of torrid

December sales. The strong pickup in merchandise sales is expected to balance out slowing growth in motor vehicle sales and

food service sales. If gasoline prices continue rising, total sales growth could even exceed 5%.

Investor takeaway

The general economic outlook remains favorable with consumer sentiment looking healthy, unemployment falling, wages moving

higher, corporate earnings are on a recovery path while oil prices are stabilizing and business capital spending is expanding.

Although frothy valuations in the stock market puts it at risk of a major correction should a major negative catalyst emerge, inve-

stors in general remain optimistic about the economy which lends more support to the Trump Trade.