What a difference a month makes. 

In early September, the energy sector was languishing. A month later, nearly everyone is a bull (although there has been some profit-taking in recent days). This week I bring you a sampling of the dramatically changed sentiment in the energy sector.

After a second quarter that saw oil demand come in stronger than expected, Citigroup is now warning that OPEC may be pumping at maximum capacity and that there is a risk of a market squeeze next year. Ed Morse, Citibank’s Global Head of Commodities Research, warned:

“Fear in the market has been that OPEC production will rise dramatically, however, there could be a supply gap emerging, which could point to a tighter market. We’re seeing more and more evidence that it’s not the international oil companies, it’s not the independent oil companies that are lagging new investments, but it’s OPEC countries lagging, particularly those five [Libya, Nigeria, Venezuela, Iran and Iraq].”

Just to be clear, the international oil companies have also slashed capital expenditures during the bear market. That will negatively impact oil and gas production in two to three years. 

Commodities trading house Trafigura suggested — “Global oil demand may be between 2 million to 4 million barrels per day more than worldwide crude supply by the end of 2019.” The last time we saw that kind of gap between supply and demand, it drove global oil prices above $100 a barrel (bbl), and it sent the share prices of oil producers much higher along with it.

News coverage at CNBC has also turned bullish in recent weeks. This week it cited an analyst who predicted that “the market’s worst-performing sector is about to rebound.” Tom Lee of Fundstrat Global Advisors stated that the current structure of the futures curve indicates that the oil price recovery is intact and “Almost always drives a rally in energy equities.”

Lee also noted that the degree to which energy stocks are trailing materials had marked a bottom for the energy sector in three periods in the past. Stocks that his firm ranked favorably include two of our favorites, EOG Resources (NYSE: EOG) and ConocoPhillips (NYSE: COP). 

Bob Pisani at CNBC reminds readers that oil has had three false starts in the past year, but then notes:

“Looks to me like it’s a rally based on fundamentals — so far. Investor sentiment is about as bad as you could ask for. There’s little money in the sector, and that is certainly a plus. The energy weighting in the S&P 500 is 7 percent. It hasn’t been that low in more than a decade.”

In my opinion, the difference in this rally and in previous rallies that fizzled is that the current one is supported by falling crude oil inventories. As long as that trend continues, so will the rally.

What might cause inventories to stop declining? OPEC could abandon its production cuts, but if you buy Ed Morse’s argument that’s not likely to yield much.

U.S. shale producers will pick up production, but that’s probably not going to be enough to keep pace with global demand growth. That could change if global demand growth slows or declines, but thus far there are no signs of that. 

It is doubtful that we see oil at $80/bbl anytime soon, but the fundamentals suggest we may finally climb out of this $40-$50/bbl range that has persisted for so long.

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