Drilling into OPEC's Goldilocks Deal

Since the financial crisis, global markets have been dominated by three macro drivers: central bank policy, currencies, and oil. While these variables are intertwined, oil has played a particularly central role in the past three years as the technological revolution in hydraulic fracking in U.S. shale fields caused massive oversupply that led to a crash in oil prices. As an example, West Texas Intermediate (WTI) oil tumbled as low as $24 per barrel this past February from more than $100 in mid-2014.

In addition to putting downward pressure on global inflation, weak oil prices hurt global capital spending, emerging markets, high yield bonds, master limited partnerships (MLPs) and strengthened the U.S. dollar. While some U.S. production cuts and better global demand allowed prices to recover into the $40-to-$50 range, excess inventories persist and remain a risk.

For investors, the oil market has remained unsettled because OPEC’s role has been in question. For the past two years, the Saudis have pursued an unconventional strategy of maximizing market share by keeping prices low rather than adhering to the traditional OPEC mandate of price stability. While some interpreted the Saudi strategy as an attempt to restrain U.S. shale producers, others saw this simply as the cartel’s failure amid increasingly complicated and shifting Middle East politics.

As a result, it is easy to understand why markets have interpreted OPEC’s Nov. 30 announcement that it would cut production next year by as much as 1.2 million barrels per day as an upside surprise. The news sent oil toward $50 and energy-related equities surged, too.

Beyond the immediate positives, we at Morgan Stanley’s Global Investment Committee believe investors need to appreciate the relevance of the deal on at least three other dimensions.

First, the OPEC deal is likely to sustain the global reflation rally beyond the oil sector, not because oil prices surge, but because they may not—instead, hovering in the “Goldilocks” range of $45 to $55 per barrel. According to Adam Longson, Morgan Stanley & Co.’s lead energy commodity strategist, if the 1.2 million-barrels-per-day OPEC cuts are executed in the first half of 2017 alongside the supposed 600,000-barrels-per-day cut from non-OPEC players like Russia, the global oil market will quickly move from the current oversupplied state to a balanced one as outlined in the chart below.

OPEC Production Cuts Suggest Oil Market Stability

This price stability will likely allow some of the energy-related economic activity that has recovered along with oil prices to continue (as an example, the Baker Hughes Rig Count is now 474, up 50% in the past six months).

This energy-related economic activity has contributed not only to a resumption of job growth in major shale regions but also to the recent upside surprise in U.S. economic indicators like durable goods orders and industrial production. As production comes back with OPEC-induced confidence, price gains should be self-correcting, with incrementally higher prices drawing in new supply. That should preserve the gasoline savings at the pump for global consumers. Oil price stability is also supportive and constructive for the rebound in emerging markets where non-OPEC producers in countries such as Indonesia and Brazil should benefit.

Another reason the OPEC deal is likely to sustain the global reflation rally is that the OPEC deal will help to maintain benign global financial conditions, which is critical given the recent surge in the U.S. dollar and rising real interest rates.

Recall that a year ago, the global economy faced circumstances similar to today’s: the U.S. dollar had strengthened significantly over a short period, the 10-year U.S. Treasury rate was around 2.25%, the Federal Reserve was preparing markets for its first rate hike in nine years, and concerns abounded that China’s growth was going to slow. With oil prices also plummeting, the world experienced tight U.S. liquidity conditions and the real rate on the 10-year U.S. Treasury surged to 80 basis points, both of which contributed to a deflationary scare and a mini-recession. High yield spreads widened, creating bankruptcy risk and raising the cost of capital for those who continued to operate.

This time, we believe higher but range-bound oil prices can serve as a shock absorber to the strong U.S. dollar by anchoring the greenback’s strength and providing offsetting inflationary pressures, while at the same time cushioning the blow for many emerging market countries dependent on U.S. dollar financing. Furthermore, stable high yield spreads support credit growth, partially countering the headwinds from higher interest rates.

Finally, and most important, we see the OPEC deal as a validation of the durability of the U.S. shale oil fracking industry, a reality that we expect will become more pronounced under a Trump administration. U.S. frackers demonstrated that they could survive with $40-per-barrel oil when the original estimate was that they would need at least $60. In fact, production in the Permian basin, which is in west Texas and southeastern New Mexico, is up 4.6% for the year to date.

In agreeing to the OPEC deal, we believe the Saudis recognized that their low-price, market-share ploy failed. Rather than destroy U.S. frackers, they were the losers; their fiscal house is in shambles, their currency peg versus the dollar is probably unsustainable; and their dreams of an initial public offering for their Aramco assets have been dashed. The final straw for the Saudis may have been the surprise election of Donald Trump.

The combination of deregulation and possible approval for the Keystone pipeline suggests even lower total marginal costs for U.S. oil producers, leaving OPEC producers ever more vulnerable in the long run.

The bottom line is that a collapse of OPEC as a price stabilizer at this juncture of the business cycle would have been a huge negative for rallying capital markets, which are trying to absorb the surging U.S. dollar and rising interest rates that have come as a result of Donald Trump’s surprise win. The fragile reflation trade should now gain tailwinds from higher inflation, stronger emerging markets, stable high yield spreads and an anchored U.S. dollar. Saudi reversal of their market-share strategy is pivotal, signaling that U.S. frackers have secured their place in the global energy market and an end to a secular cycle of globally tight oil markets.

Investors should watch for oil prices to remain in the range of $45 to $55 per barrel, which would validate the Goldilocks scenario. Investors may also want to consider master limited partnerships as a way to optimize total returns from the oil patch. Focus on midstream transporters that are leveraged to stable volume.