Energy

We recommend deploying the proceeds of our E&P downgrade into oil & gas field services. The typical conditions required for energy services share price outperformance are falling into place. First, oil consumption is growing relative to production. OPEC production has continued climbing even as non-OPEC output has contracted, underscoring that a deal to curb future output should ensure that the consumption/production ratio stays in an uptrend. Recent strength in emerging market (EM) currencies signals that non-OECD oil consumption can continue to grow via better purchasing power, and also reduces the odds of an EM financial credit accident. Second, OECD oil supply growth rates appear to have peaked. Third, oil & gas field services pricing power has troughed. We doubt there is much upside given the scale of the excess capacity that was built up in the last decade, but an end to deflation would take away a large negative. Finally, the rig count has ticked higher, and has more upside if firms shift out of maximum retrenchment mode. Relative valuations are sufficiently cheap enough to expect that even a modest increase in the rig count could spur a re-rating. Boost the S&P oil & gas field services index to overweight. bca.uses_in_2016_10_12_002_c1 bca.uses_in_2016_10_12_002_c1

The energy sector is up marginally from its lows when compared with the overall market, an abysmal performance given the rally in crude oil and natural gas. Our strategy has been to keep only a market neutral weight on the overall sector this year via an overweight in oil & gas producers and underweight in refiners. While this has served our portfolio well, we are fine-tuning our intra-sector exposure. OPEC recently agreed to make a modest production curtailment. Whether members adhere to quotas and/or actually reduce output remains to be seen, but the more important point may be that the quest to drive down prices to cause financial pain for high cost producers appears to have come to an end. BCA's Energy Strategy Service believes that despite significant improvements in drilling efficiency and productivity during the downturn, current drilling levels are 30-40% lower than needed just to stem production declines. Re-inflating the rig count to an expansionary level will take time (~6 months), and then realized production will lag the rig count by 4-6 months. Renewed acceleration in drilling and completion activity will create inflationary pressures: pricing power will shift in favor of services firms relative to producers at a time when oil & gas extraction labor cost inflation has spiked to double-digit rates (third panel). If commodity prices are flat, it will be difficult for E&P firms to grow cash flow unless production is on the upswing. Take profits of 15% and downgrade the S&P oil & gas exploration & production index to neutral, funneling the proceeds into energy services firms, see the next Insight. bca.uses_in_2016_10_12_001_c1 bca.uses_in_2016_10_12_001_c1

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

At last year's BCA New York Investment Conference, I made five controversial predictions. This week's <i>Special Report</i> looks at how they have panned out.

We put the odds of an oil-production freeze agreement between OPEC and Russian officials next week in Algiers at slightly better than a coin toss.

Fed policy - and, importantly, policy expectations' effect on the broad trade-weighted USD (TWI) - will dominate price evolution over the short term, as markets puzzle out if and when a rate hike is coming this year.