Energy

While the post-GFC linkage between oil prices and medium-term inflation expectations evident in the 5-year/5-year (5y5y) CPI swaps market will continue to be debated for years to come, this is an empirical fact that will affect monetary policy and the evolution of FX and real interest rates over the medium term.

The old cyclical market axiom that "nothing cures low prices like low prices" has never held
truer than in today's oil market.

Lower oil prices are aggravating financial and social stress in poorer OPEC states, particularly in Venezuela, where the government recently executed a gold-for-cash swap ahead of looming debt payments.

The Fed's decision to scale back intended interest rate hikes reflects economic reality.

We differ markedly with the U.S. EIA's assessment of the near-term evolution of oil supply and demand.

The wide WTI - Brent differentials at the front of these respective curves will continue to incentivize crude-oil exports from the U.S. to European refiners, who tend to favor the light-sweet crude coming out of LTO plays.

The relief rally is not over, and could benefit from commodity and currency market movements. Oil prices likely are banging out a bottom. In general, however, a healthy dose of caution is warranted. Our bias is to sell into, rather than chase, rallies in risk assets.

A stunning 9.9 million-barrel build in U.S. oil inventories this week failed to arrest the upward climb in prices.

The remarkable admission by OPEC's secretary-general, Salem el-Badri, earlier this week that with "any increase in (oil's) price, shale will come immediately and cover any reduction" in output only hints at the larger impact of light-tight-oil (LTO) going forward.

The sheer scale of underperformance leaves the oilfield services group vulnerable to violent bounces, especially in view of the recent stabilization in oil prices as well as an agreement between several OPEC members and Russia to freeze output at current levels. Is it time to buy? While oil supply will eventually be reined in, demand growth is still up for debate. The global economy is struggling to maintain a decent rate of growth. Importantly, energy service stocks have an abysmal track record during recessions and/or when the ISM manufacturing index is below the boom/bust line. In other words, the group is a late-cycle performer, not an end-of-cycle performer. While the U.S. is not technically in recession, the odds of one are rising steadily as credit conditions tighten. Even then, upside potential may be more muted than in previous cycles. Fracking technology and producer's flexibility to quickly ramp up output suggests that the large boom/bust cycles in supply will not hold true going forward. The natural gas market is a prime example. The implication for oilfield services investors is that peak earnings could be much lower than in the past, which will reduce investor willingness to speculate on upcycles and warrant a higher risk premium. We are sticking with a neutral weighting, despite the likelihood of periodic oversold spikes. The ticker symbols for the stocks in this index are: SLB, HAL, BHI, CAM, NOV, FTI, HP, RIG, ESV, DO. bca.uses_in_2016_02_23_001_c1 bca.uses_in_2016_02_23_001_c1