Oil How Low Can It Go?

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1 WEEKLY GUIDANCE FROM OUR I NVESTMENT STRATEGY COMMITTEE John LaForge Head of Real Asset Strategy Oil How Low Can It Go? Key takeaways June 18, 2018» At $67 per barrel, WTI (West Texas Intermediate) oil prices look high to us. Global supply growth continues to outpace demand growth.» In addition, Saudi Arabia has floated the idea of increasing oil production. What it may mean for investors» We are expecting WTI crude-oil prices to head into the $50s by the end of Not every mistake is a foolish one. Cicero Gasoline prices have been the hot topic in And rightfully so. Gas at the pump now averages $2.91 per gallon about 20% higher than it was at this time last year. 1 A few weeks ago, the average price came close to the psychological threshold of $3.00 per gallon level, which is one reason why we are fielding so many gas and oil questions today. Asset Group Overviews Equities... 6 Fixed Income... 7 Real Assets... 8 Alternative Investments... 9 Fortunately for summer drivers, average U.S. gas prices did not climb above $3.00 per gallon. This is because oil prices hit a wall at around $73 per barrel, and have since slipped back to $67. This can be seen in Chart 1, which shows the price of WTI crude oil. The shaded area represents our target price range for the next 12 months. The midpoint of our range is $55. The fact that our 12-month target of $55 per barrel is lower than today s $67 WTI oil price is obvious. In today s report, we will discuss why we re expecting lower oil prices over the next year. 1 U.S. Department of Energy, Average price of regular unleaded gas in the U.S., June 13, Wells Fargo Investment Institute. All rights reserved. Page 1 of 10

2 Oil How Low Can It Go? Chart 1. WTI oil price and Wells Fargo Investment Institute (WFII) 12-month target range WTI oil price (U.S. dollars per barrel) WTI oil price WFII 12-month target range WTI oil price (U.S. dollars per barrel) Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Source: Wells Fargo Investment Institute, June 13, West Texas Intermediate (WTI) is a grade of crude oil used as a benchmark in oil pricing. In complete candor, we never expected the price of WTI oil to hold much above $60 in We have been wrong as WTI finished 2017 at $60 and has closed above $60 nearly every day since. So, for the first half of 2018, we say, mea culpa. Markets can be quite humbling, and stories can change, so we always remain open to adjusting our stance. In the case of oil, we are not changing our bearish stance. The case for lower oil prices continues to build. As for why we re sticking to sub-$60 WTI oil prices, the primary driver is too much supply. Chart 2 highlights the world s top petroleum-producing (oil-producing) countries. Notice U.S. oil production (shown in the blue line), which is hitting record highs. This is due to a combination of high prices, and the rise of shale oil production. Further, an end to record production levels does not seem to be in sight. To stop this ascent and force U.S. producers to slow down, we ll likely need to see lower oil prices. With such a swelling in U.S. oil supplies, a rational person could think that prices should have faded by now. We certainly did. But that has yet to happen as some other major oil-producing countries have conspired to restrict their own production namely Russia, Saudi Arabia, and the rest of the Organization of Petroleum Exporting Countries (OPEC). This also can be seen in Chart 2. Russia is shown in the green line; Saudi Arabia is tracked by the purple line Wells Fargo Investment Institute. All rights reserved. Page 2 of 10

3 Oil How Low Can It Go? Chart 2. Production levels of top petroleum-producing countries Iran China Russia Saudi Arabia U.S. Millons of barrels per day Sources: Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, 1982 May 31, As 2018 has progressed, we have wondered how long Russia and OPEC could continue to restrict their production. After all, rising global prices create their own sort of internal pressures to capitalize upon higher prices. In the case of Saudi Arabia, as an example, oil revenues are used to fund social programs, government bonuses, etc. Russia, as another example, needs the U.S. dollar inflow (oil is largely traded in U.S. dollars), to do its business outside of Russia. The other big negative here for Russia and OPEC is that the longer they restrict production, the more they are losing market share to the U.S. Chart 3 highlights this dynamic. The blue bars represent total world production, around 98 million barrels per day. The green line is U.S. market share, which stands at 18%. This may not sound like much, but a decade ago, the U.S. produced only 10% of the world s oil. On the other hand, OPEC s market share (Chart 3, red line) has slipped in the past decade from 43% to 39%, and it continues to slide. The time for Russia and OPEC to release production restrictions may be near. We say this because Saudi Arabia floated the idea at the end of May. This is a 180-degree turn in rhetoric from OPEC communication in 2016 and And the market reacted, as we suspected that it would. WTI oil prices dropped nearly 10%, after the Saudi announcement Wells Fargo Investment Institute. All rights reserved. Page 3 of 10

4 Oil How Low Can It Go? Chart 3. U.S. and OPEC oil production versus global production Global production (right scale) OPEC production as % of global (left scale) U.S. production as % of global (left scale) Oil production % of global Million barrels per day Sources: EIA, Wells Fargo Investment Institute. Yearly data: Data for 2018 is the average of the monthly oil production to date. Overall, the balance between supply and demand continues to tip on the side of too much supply. Chart 4 shows the balance between growth in global supply and demand. A falling green line means that global supply is growing at a faster rate than demand is. When this has happened historically, oil prices have eventually given in and faded, too. (Oil prices are represented by the blue line in Chart 4.) Chart 4. Brent oil price versus global oil demand/supply balance Global demand growth minus supply growth (%) Global demand growth minus supply growth YoY (12 month average) Brent crude Brent crude price (U.S. dollars per barrel) Sources: U.S. Energy Information Administration, Bloomberg, Wells Fargo Investment Institute. Monthly data: January 2002 May 31, Brent crude is a light, sweet oil produced in the North Sea and is used as a global benchmark for oil pricing Wells Fargo Investment Institute. All rights reserved. Page 4 of 10

5 Oil How Low Can It Go? Lastly, we ll end with $67 oil prices, from the perspective of my 16-year-old daughter. We repeatedly hear that oil prices should be higher, if only because $67 is too low historically (adjusted for inflation). Our answer, in 16 year-old speak is ah, no that is literally not true. Chart 5 shows oil prices, adjusted for inflation, back to the first time that oil was found and produced in the U.S., around Today s $67 price is about twice the historical average of $35. So, no, prices today are not low. In fact, they are quite high, historically speaking. The bottom line is that $67 WTI prices look high to us. We are expecting WTI oil to head into the $50s by the end of Chart 5. Crude oil prices (inflation-adjusted) 128 Oil price (inflation-adjusted) Average Oil prices (U.S. dollars per barrel) Sources: Bloomberg, Minneapolis Federal Reserve, BP statistical review, Wells Fargo Investment Institute. Yearly data: Log scale. Prices from 1861 to 1950 are taken from BP statistical review. Prices from 1951 to April 1983 are Bloomberg Arabian Gulf Arab Light Crude Spot prices, and prices from May 1983 to current are Bloomberg West Texas Intermediate Cushing Crude Spot price data is an average of daily prices as of June 14, Prices adjusted using inflation data provided by the Minneapolis Fed from onward inflation data is estimated by the Consumer Price Index (CPI) Wells Fargo Investment Institute. All rights reserved. Page 5 of 10

6 EQUITIES Sameer Samana, CFA Global Equity and Technical Strategist U.S. Small Cap Equities Favorable U.S. Large Cap Equities Favorable U.S. Mid Cap Equities Developed Market Ex-U.S. Equities The going gets tougher Since the February equity-market pullback, we have written that, from a technical perspective, we expect the S&P 500 Index to consolidate and then convincingly break out to the upside. The chart below shows that markets have followed this script thus far, as we have seen a solid rally. Yet, the S&P 500 Index now is entering an area where multiple resistance levels may come into play. The first zone begins at the February 2018 high (2780) and continues up to the psychologically-important 2800 area. The second zone starts at the all-time S&P 500 Index high (2873), and the upper bound should be the psychologically-important 2900 level. We also recently wrote about seasonality and how June, August, and September tend to be weaker months for S&P 500 Index performance. This historically tough stretch coincides with the run-up to this year s midterm elections, which could be an added source of uncertainty and market turbulence. Interestingly, investor sentiment has been becoming more optimistic, and volatility measures have been grinding lower. We believe that this represents an opportunity for investors to position ahead of the potentially choppy period. In our view, the timely strategy now would be to trim overallocation to equities especially any excess exposure created by the recent equity-market appreciation back to strategic weightings. Key takeaways» The U.S. equity market s rate of appreciation should slow as technical resistance comes into play, as we enter a historically weak period, and as political uncertainty increases ahead of the midterm elections.» Markets generally are not positioned for volatility and could be caught off guard by another bout of choppiness.» In our opinion, investors can capitalize upon this situation by rebalancing portfolios and ensuring that they are not taking more equity risk than is appropriate for the market environment and their goals and risk tolerance. S&P 500 Index (SPX) versus 50- and 200-day moving averages for SPX Index Emerging Market Equities Source: Bloomberg, June 13, The moving average looks at the average price of a particular stock (or sector, market or asset class) over a rolling time period. This creates a smoothed price trend line, which is an indicator used in technical analysis. There is no assurance that these movements or trends can or will be duplicated in the future. Technical analysis is only one approach used to analyze stocks. The S&P 500 is a market capitalization-weighted index generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 6 of 10

7 FIXED INCOME Brian Rehling, CFA Co-Head of Global Fixed Income Unfavorable U.S. Taxable Investment Grade Fixed Income Favorable U.S. Short-Term Taxable Fixed Income U.S. Intermediate Term Taxable Fixed Income Most Unfavorable U.S. Long-Term Taxable Fixed Income Unfavorable High Yield Taxable Fixed Income Unfavorable Developed Market Ex.-U.S. Fixed Income Preferred stock evaluating the income risk We recently downgraded our overall view of the credit sector and investment-grade corporate securities to neutral from favorable. Within the credit sector, preferred securities remain our top pick (with favorable guidance). Many preferred securities offer yields near 5.5%. The preferred-security sector remains among the highest yielding fixed-income sectors. For investors, we believe the main attraction in owning preferred stock today should not be price appreciation. Rather, the focus should be on income generation. Over the past five years, preferred securities have experienced no price appreciation (see chart below). Yet, the price chart of the S&P Preferred Stock Index does not capture the substantial income that can be generated from these securities. A total-return view of the preferred sector shows that over the past five-years the preferred-securities sector was among the best returning fixed-income sectors that we track. Through June 12, 2018, the fiveyear average annual return of the S&P U.S. Preferred Stock Index was 5.5%. There are a number of features that investors may embrace when adding higheryielding securities to their portfolio. These can include longer maturities, lower credit quality, less liquidity, and a loss of structural protections. Preferred securities contain most, if not all, of these qualities. Should we enter a period in which the markets become risk-averse, and/or interest rates rise sharply, we would expect preferred securities to fall in value. Investors should not purchase allocations in the preferred-security sector or any sector without a full understanding of the sector s risks. Key takeaways» Given the higher volatility of the preferred-security sector, we believe that exposure to this sector should be diversified among a variety of issuers, sectors, and structures. We strongly recommend that investors consider a professional manager to oversee their preferred-stock allocations.» As the credit cycle continues to mature, the potential for a credit-based correction in the preferred sector will increase.» We currently have a favorable view of the preferred-security sector. S&P Preferred Stock Index Favorable Emerging Market Fixed Income Index value /12/2013 6/12/2014 6/12/2015 6/12/2016 6/12/2017 6/12/2018 Source: Bloomberg, June 13, The S&P Preferred Stock Index seeks to track the investment results of an index composed of U.S. preferred stocks. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 7 of 10

8 REAL ASSETS Austin Pickle, CFA Investment Strategy Analyst The power to question is the basis of all human progress. --Indira Gandhi The U.S. is the new kid on the (global oil) block Unfavorable Commodities Private Real Estate Public Real Estate In the cover article of this report, Chart 3 shows that OPEC s share of global oil production has faded, while the U.S. share has risen dramatically. The majority of this additional U.S. supply satisfies a growing percentage of U.S. oil needs, at OPEC s expense (U.S. crude-oil imports from OPEC have dropped from 5.8 million barrels per day [mmbd] in 2008 to just 2.5 mmbd today). Historically, increased U.S. oil production only impacted the U.S. market. This is because the U.S. had banned crude-oil exports in Yet, in December 2015, that ban was lifted. OPEC now has to contend with U.S. producers in global oil markets. As the U.S. historically has been a crude-oil importer, the majority of its infrastructure is built to handle oil coming in, not out, of the country. Further, despite record oil production, the U.S. still consumes more oil than it produces. These factors contributed to a slow start for U.S. crude-oil exports. But with the U.S. shale industry going gangbusters, while OPEC and Russia have curtailed production an interesting thing happened the price difference between the U.S. crude-oil grade (WTI) and the global benchmark (Brent) blew out, and exports tripled (chart below). Today s $10 spread between these prices is a strong incentive for U.S. producers to continue to ship oil overseas. This means that OPEC must now worry about U.S. producers grabbing market share from not only the U.S. but also from everywhere. Key takeaways» The U.S. is now able to export crude oil (after lifting the ban in December 2015).» With such a wide spread between Brent and WTI oil prices, OPEC must contend with U.S. oil exports grabbing global (not just U.S.) market share. U.S. crude-oil exports versus spread between WTI and Brent crude-oil prices 12 Spread (Brent oil price - WTI oil price) U.S. crude oil exports (four week average) 2.5 Brent minus WTI spread (U.S. dollars) Dec-15 Apr-16 Aug-16 Dec-16 Apr-17 Aug-17 Dec-17 Apr U.S. crude oil exports (million barrles per day) Sources: Bloomberg, Energy Information Administration, Wells Fargo Investment Institute. Weekly data: December 18, June 8, Wells Fargo Investment Institute. All rights reserved. Page 8 of 10

9 ALTERNATIVE INVESTMENTS Justin Lenarcic Global Alternative Investment Strategist Private Equity Hedge Funds-Macro Hedge Funds-Event Driven Favorable Hedge Funds-Relative Value Most Favorable Hedge Funds-Equity Hedge Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to accredited or qualified investors within the meaning of U.S. securities laws. Merger mania in 2018 Last week s decision by a federal judge to allow the $85 billion merger of two leading U.S. media companies is expected to usher in a wave of deal activity. Vertical mergers of this size have faced increased antitrust scrutiny in recent years, leading to several deal breaks and losses for Event Driven hedge funds. While this decision does not eliminate the need for regulatory approval of corporate deals, it has (at least temporarily) removed some uncertainty. While this approval likely will result in more deals, especially within the competitive telecommunications sector, it is important to note that year-to-date global merger and acquisition volume has risen by 65% versus last year and that it is nearly as robust as it was in In other words, corporate deal activity has accelerated (regardless of the deal approval last week). This is because the conditions for increased corporate activity stable economic growth, high corporate cash balances, and low rates remain in place. We have a strong preference for managers that take a more tactical, trading-oriented approach to Merger Arbitrage, rather than the old school, buy and hold trade structure. The chart shows the speed with which deal spreads can change, which requires constant monitoring and sizing when trying to arbitrage shares of an acquirer and their acquisition target. While deal spreads may be less affected by antitrust scrutiny going forward, we still anticipate elevated volatility (given the complexity of deals). Key takeaways» Corporate deal activity may accelerate following the approval of this large-scale merger, but activity already was approaching historically high levels.» Given the complexity of deals, we expect elevated spread volatility to remain in place, and we prefer tactical Event Driven managers. Recent increase in merger arbitrage spread volatility is expected to continue Merger arbitrage spread (%) 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Average merger arbitrage spread (North American targets, including all spreads) Source: UBS, June The chart above shows the average merger arbitrage spread of deals involving North American publicly traded target companies (those tracked by UBS). The spreads are the excess return over LIBOR that the merger arbitrage trades offer at a given point in time. The merger arbitrage return is derived by the difference between a target company s current stock price per share and the expected acquisition price per share. LIBOR is the London Interbank Offered Rate, which is the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London. The merger arbitrage spreads provided are net spreads and factor in the effect of any dividends, optionality, and short rebates (stock loan rebates), on a LIBOR-adjusted basis. In other words, the chart shows the spread over the risk-free rate. (The stock loan rebate, or short rebate, is the amount paid by a stock lender to a borrower who has provided cash collateral to borrow a stock.) In other words, the chart shows the spread over the risk-free rate. 2 Citi, Event Driven Snapshot, May Wells Fargo Investment Institute. All rights reserved. Page 9 of 10

10 Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 10 of 10