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Don’t Look Now but the Oil Market is Turning Bullish

Matthew DiLallo, The Motley Fool

Not that long ago analysts were throwing in the towel on the oil market, with some growing downright bearish. In late June, for example, analysts at Seaport Global Securities downgraded more than 50 oil stocks in one swoop after changing their mind on oil prices, which they saw crashing back into the $20s early next year. However, a gusher of bullish data over the past couple of months has quickly changed the oil market's tune.

That wave of data has already quietly fueled a new bull market in oil, which has taken several oil stocks off their lows. Because of this, an increasing number of industry prognosticators are revising their oil price forecasts upward, while others are starting to worry about the growing risks that could fuel a massive spike. If this renewed bullishness continues, oil stocks could go much higher.

A silhouette of an oil pump in an oil field at sunset.

Image source: Getty Images.

What's fueling this bullish wave?

Three factors are driving the renewed optimism in the industry. First, oil demand has been stronger than expected this year. Second, shale drillers tapped the brakes when prices dipped into the $40s, which will lead to slower production growth in the near-term. Finally, those factors, when combined with OPEC's production cuts, are making a meaningful dent in oil storage levels.

Just this week the U.S. Energy Information Administration (EIA) reported that crude stockpiles in the country fell by another 5.7 million barrels, which was 1.5 million barrels more than analysts expected. While inventories remain near the upper limit of the range for this time of year, that's an improvement considering that they had been well above that level for quite some time. Bob Dudley, the CEO of oil giant BP (NYSE: BP) put it best when he said at a recent industry conference that "the swimming pools are draining." The BP CEO further noted that "stock levels are just heading down, for both crude and [refined] products. So it does seem we're heading toward the targets that were set by OPEC." Because of that, he thought crude looked like it would at least stabilize around the current price.

Meanwhile, that improving data is driving others to reverse their dour outlook on crude prices. The EIA, for example, recently changed its oil price forecast, bumping its Brent estimate up $1 this year and by $2 in 2018 while moving its view for WTI up by similar amounts. That revision comes just one month after the EIA seemed to throw cold water on an oil market recovery by reducing its oil price forecasts and its outlook for U.S. oil production growth, which at the time suggested that despite lower projected output from shale drillers in 2018, the oil market would remain oversupplied.

A beam of light shining through an oil pump at sunset.

Image source: Getty Images.

More upside ahead?

Those upward revisions from the EIA and others could continue coming if the current momentum in the oil market keeps up. One driver of that view is that OPEC appears poised to maintain its output reduction pledge deeper into 2018. While the current agreement will expire in March, a recent report by Reuters suggested that the group was leaning toward extending its pledge by another nine months. That would drain even more supplies out of storage, providing a firmer floor under crude prices.

Meanwhile, one of the biggest issues weighing on oil prices earlier this year was that shale drillers quickly ramped up their drilling activities and output, offsetting a portion of OPEC's reduction. However, many promptly slowed down when oil prices slumped this summer to better match their budget with expected cash flow. Meanwhile, several stronger producers have recently turned their attention away from how fast they could grow output in the current price environment to how much cash they could return to shareholders.

For example, Anadarko Petroleum (NYSE: APC) recently unveiled a $2.5 billion share repurchase program, which it saw as an "attractive use of cash" when considering its options, including drilling more wells. In this case, Anadarko could buy back as much as 10% of its outstanding shares, which would fuel a similar growth rate in production on a per-share basis without adding any more oil to a still saturated market. That's why investors applauded the move, sending shares up double-digits over the past month. Meanwhile, Encana (NYSE: ECA) recently announced that it's well ahead of pace on its five-year plan thanks to continued innovation gains. Because of that, Encana believes it can increase its cash flow by a 25% compound annual rate through 2022. However, instead of using that rapidly rising cash flow to accelerate production growth, Encana anticipates generating $1.5 billion in excess cash without any improvement in oil prices, which it can use to create value for investors.

Progress and prudence could power more gains

As long as no one gets greedy by rapidly ramping up oil output, then the oil market's fundamentals will continue improving. That steady progress could be just the fuel needed to ignite a buying wave that could send oil stocks much higher, especially for companies like Anadarko and Encana, which plan to focus on creating shareholder value instead of growing at all costs. That's worth noting because while both stocks have risen sharply in the past month thanks to higher oil prices and their shareholder-focused plans, Encana is only up 1% this year, while Anadarko has fallen a stunning 30%, suggesting that investors haven't completely missed out on their upside potential.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.