Surging US Oil Production Head Wind For Energy ETFs

Earlier this week, Saudi Arabia's energy minister expressed confidence that the production cuts announced by OPEC and Russia in November will end by the middle of the year.

“All players have indicated their willingness to extend [the cuts beyond midyear], if necessary,” Saudi Energy Minister Khalid Al-Falih said. “Based on my judgment today, I think it’s unlikely that we will need to continue. We don’t want to create a shortage or a squeeze, so the extension will only happen if there’s a need.”

Based on his comments, the Saudi minister seems to believe that the agreed-upon output reductions―which went into effect Jan. 1 and will last for six months―will quickly balance the oil market and remove the glut of crude that currently exists in global inventories.

But a look at the performance of oil prices and energy ETFs since the cuts were announced suggests that investors and traders are skeptical that the deal will have a meaningful effect on the market.

Muted Reaction Since Announcement
During the first week of 2017, WTI crude oil futures briefly topped $55 for the first time in a year-and-a-half, but prices since retreated and are only up about 3.5% since the output reduction agreement was first announced on Nov. 30.

Energy ETFs have done even worse since then. The United States Oil Fund (USO) rose 2%; the Energy Select Sector SPDR Fund (XLE) edged up by 0.5%; and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) fell by 2.3% in the period.

Returns For Crude Oil Futures, USO, XLE, XOP Since Nov. 30

The muted reaction in oil prices and energy ETFs since the end of November means that investors don't consider the OPEC-Russia pact to be a game changer for the oil market―and they're right about that.

For one, it's highly unlikely that the actual cuts will end up anywhere close to the 1.8 million barrel per day reduction that OPEC and Russia have promised. Historically, producing countries have cheated on the quotas they are supposed to abide by.

OPEC's output was at a record 34.2 million barrels per day in November, led by output gains in Iraq and Iran. Neither of those countries is likely to cut back. It's also hard to imagine that Russia, where oil production soared to an all-time high of 11.3 million barrels per day at the end of last year, will abide by the deal.

*No cut proposed. Data in million barrels per day. Source: International Energy Agency

US Oil Production Surges

The only countries that may stick to the agreement are Saudi Arabia and a few of its small Gulf allies such as the UAE and Kuwait. Moreover, whatever amount supply does come down by―the Kingdom promised half a million barrels per day worth of cuts of its own―will be quickly made up for by U.S. producers. An article on ETF.com hinted at this back in November, but since then, it's become even clearer.

According to the latest data from the Energy Information Administration, U.S. crude oil production jumped to 8.95 million barrels per day during the first week of January, up more than 500,000 barrels per day from the lows of 2016, as producers ramped up drilling activity following the doubling of oil prices during the year.

US Oil Production (thousand barrels per day)

In a matter of months, production in the country has recovered almost half of its total decline from the industry downturn. With prices consistently above $50 in recent weeks, it's reasonable to expect that U.S. supply will keep rising, easily making up for any OPEC reductions.

By midyear, when the current round of OPEC-Russia cuts are set to expire, it will become increasingly clear that U.S. producers are eating the cartel's lunch, and that it was folly to try and prop up oil prices artificially.

Mixed Outlook For Energy ETFs

With all that said, it doesn't mean energy ETFs are a bad bet. If oil prices retreat, that certainly spells bad news for oil-tracking funds such as USO, but energy equity ETFs are a different animal. Funds such as XLE and XOP are influenced as much by U.S. production growth as oil prices. If U.S. producers steal market share from OPEC, that bodes well for many energy stocks.

Still, the easy gains have already come and gone. Energy was the best-performing sector of 2016, rising 28%. Unless oil prices take off again in 2017―the evidence suggests they won't―returns for energy ETFs won't be as hot as last year.

At the time of writing, the author did not own any of the securities mentioned. Contact Sumit Roy at [email protected].