MRP MCALINDEN RESEARCH PARTNERS JOE MAC S MARKET VIEWPOINT. CONTRARIAN CRUDE CALL Market Viewpoint: April 28, 2017

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1 MRP MCALINDEN RESEARCH PARTNERS JOE MAC S MARKET VIEWPOINT CONTRARIAN CRUDE CALL Market Viewpoint: April 28, 2017 Ever since crude oil prices bottomed early last year, the trend has been undeniably up, but clearly not up in a straight line. There have been several steep corrections along the way. Oil prices fell by over 10% from mid-december to late March and oil-related equities did even worse: a double-digit dip occurred as traders panicked over record high U.S. crude inventories. Nonetheless, each time crude has dipped more than 10% over the past year, it has proven to be a buying opportunity for oil stocks, and MRP believes the same will be true this time: Energy equities will turn out to be a top performing sector in 2017 with oilfield services leading the pack. MRP first added the U.S. energy sector as a new theme with the publication of the April 2016 Viewpoint Implications of the Coming Shortage of Oil. We argued that the massive cutback in energy capital expenditures, combined with the shrinkage in energy workers, and drying up of financing options would lead to a shortage of oil. The report also opined that the freeze agreement that had been announced by some major OPEC members and Russia may have marked a turning point in the trajectory for crude prices. Altogether, these forces, MRP wrote, would boost prices to the $60-80 range. Not long after our initial report, oil prices rallied to over $50 a barrel and sentiment turned much more positive by the late spring. But over the past several months, record high U.S. crude inventories have swung trader sentiment back the other way yet again. The conventional wisdom now seems to be that the global oil glut will persist indefinitely. Bearish observers reason that any increase in prices will bring on self-destructive increases in production. MRP s view is now once again quite contrarian. The reduced level of production around the world, combined with stronger than expected demand will result in a second leg up for the oil price recovery. Notwithstanding all the fear mongering in the media about the oil shale fracking rebound and record high inventories, we continue to be enthusiastic about the oil shortage theme. It looks to us like the singular focus of traders on U.S. crude stocks has ignored the rolling over in total U.S. petroleum inventories as well as the significant declines in production and inventories outside of the U.S. Moreover, MRP believes there is a growing probability of a demand shock as early as this summer. Our reasoning is simply based on our interpretation of the supply/demand facts. Joseph J. McAlinden, CFA, is the founder of McAlinden Research Partners (MRP) and its parent company, Catalpa Capital Advisors. He has 50 years of investment experience. Mr. McAlinden founded Catalpa Capital in March 2007 after leaving Morgan Stanley Investment Management where he had spent 12 years, serving first as chief investment officer and later as chief global strategist. During his 10-year tenure, as chief investment officer, he was responsible for directing MSIM s daily investment activities and oversaw more than $400 billion in assets. As chief global strategist, he developed and articulated the firm s investment policy and outlook. Prior to Morgan Stanley, Mr. McAlinden held positions as chief investment officer at Dillon Read and as President & CEO of Argus Research. Mr. McAlinden frequently appears in the financial media including Bloomberg Television.

2 Thousands of Persons Joe Mac s Market Viewpoint April 28, 2017 Page 2 of 5 First, let s look at U.S. oil drilling activity. There has clearly been a rebound, as evidenced by the Baker Hughes rig count data. The number of active U.S. oil rigs peaked at 1609 in October The rig count then plunged to a sixyear low of 316 in May 2016but has since increased to 697 as prices have rallied to above $50 per barrel. Drillers have roughly doubled the number of rigs since the 2016 trough. It is noteworthy, however, that the doubling of the rig count still leaves the number down by almost 1000 rigs or 60% below the 2014 peak. Still, rigs are reportedly now 40% more efficient than they were just a year ago. Production, as a result, has rebounded by far more than the rig count. U.S. oil production peaked in June 2015 at 9.6 million barrels a day and then fell by 1.2 million to its low of 8.4 million. It now has recovered from that low to its latest reading of 9.2 million barrels a day, effectively making up more than half of what was lost. Nonetheless, investors may be dramatically overestimating the expected price impact of the rebound in rig counts and U.S. production. A common assumption is that U.S. fracking has revolutionized the world s oil and gas supply, and despite the fact the price of oil is now lower, producers are still increasing production and deploying new oil rigs which will keep prices from going up much higher. But the story is more complicated. Oil and Gas Employees Beginning with the 2014 plunge in oil prices which lasted until early 2016, when prices hit bottom in the high 200 twenties, the number of incomplete wells started to grow rapidly because some producers were forced to close rig development projects. When oil prices started to recover, suprisingly, the number of unfinished wells continued to rise. In February alone, 95 wells were not completed out of 2007 Source: BLS Fred This seemingly counter-intuitive behavior can be explained by the type of contract that producers lease the land on. Some contracts require drilling within a certain time period but they do not require production, while others oblige the producers to drill a new well every six months. The efficiency of oil rigs reportedly increased almost 40over the past year, partially explaining the greater production rebound. This may also explain why production is up so much, even though employee headcounts are not.

3 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Thousand Barrels Million Barrels Thousand Barrels Joe Mac s Market Viewpoint April 28, 2017 Page 3 of U.S. Ending Stocks excluding SPR of Crude Oil (Left) 450 U.S. Field Production of Crude Oil (Right) Srouce: EIA Weekly U.S. Ending Stocks excluding SPR of Crude Oil and Petroleum Products Weekly U.S. Ending Stocks excluding SPR of Crude Oil Weekly Finished Petroleum Products Production & Inventories Crude Oil and Petroleum Products Inventories There is also, however, the issue of a steady rise in offshore production. Media reports have been pointing to shale drillers as the cause of oversupply, yet there are other culprits. Offshore wells in the Gulf of Mexico produced an additional 220,000 barrels a day, which contributed to the growth in U.S. production between September and December, accounting for more than a quarter. Offshore wells and projects take much longer than onshore projects, possibly years, to start to produce. Meanwhile, shale drillers can recover relatively quickly, in the range of months. Coincidentally, offshore production was acceraleration during the period from October to March, when total shale oil production was hovering between 4.7 and 4.9 million barrels a day. The production rebound is partly responsible for the stunning rise in U.S. crude inventories, which had been generally stable for over two decades. They started climbing at the end of 2014, reaching a new all-time high just a few weeks ago Refinery Operable Capacity Utilization 90.8 But total commercial inventories (sum of crude and finished product inventories) have clearly been rolling over, as shown by the blue line in the chart. As crude stocks have risen, gasoline and other product inventories have also fallen Another major factor behind the unusually high inventories has been this year s refinery maintenance season, during which a large portion of heavy refinery equipment

4 Joe Mac s Market Viewpoint April 28, 2017 Page 4 of 5 goes through inspection and repairs. It is a rolling four year process. Durjng this so called maintenance season, which takes place each winter and ends around March or April, the oil industry shifts production towards a summer-blend refined oil. This year in March, refinery utilization was said to be the lowest since 2013, although it is already rebounding. As, utilization rates increase, crude inventories will be drawn down and oil prices will recover. Moreover, it is important to consider activity beyond the U.S. market. A recent OECD report gauges that overall global inventories have actually been falling for five consecutive months. Elsewhere in the world, OPEC and some other producing nations announced plans last year to cut crude production by 1.8 million barrels a day, over twice more than the U.S. production rebound of over 800,000. Compliance with the 5-yr Moving Average (Million Barrels) OPEC agreement was 94% in February 450 and 104% in March. OPEC s Secretary- General, Mohammad Barkindo, 400 recently commented that the market is slowly achieving balance and that 350 stockpiles are decreasing as a result of the output cuts. In mid-april, the 300 International Energy Agency reported that, owing to the decreasing 250 inventories in developed markets, Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 supply is close to meeting demand. Saudi Arabia s oil minister sent a clear message at the beginning of March, that Saudi Arabia will not bear the burden of free riders, nor will it buttress U.S. shale producers and give up its market share. On the other hand, the kingdom is on its way to list 5% of Saudi Aramco, in what will be the biggest IPO ever, at a valuation north of $1.5 trillion if the Saudis get their way. Therefore, despite the saber-rattling, our sense is that Saudi Arabia has a vested interest in higher not lower oil prices, regardless of the short-term market share sideeffects of OPEC s reduced production. In fact, Saudia Arabia has said that it may extend its oil production cuts past June. Such an extension will only be confirmed once OPEC members meet on May 25 and decide whether they will prolong the production cuts. Oil demand has consistently increased for decades and is predicted to reach 100 million bpd by 2019 and 104 million bpd by The drivers of the growth will be developing nations, led by China and India.

5 Joe Mac s Market Viewpoint April 28, 2017 Page 5 of 5 The U.S., however, is still the world s leading gas guzzler. Consumer sentiment is at all-time highs, and gasoline prices still relatively low. Miles driven are already at record levels and could deliver a big upside surprise this summer. In addition, there are increasing signs that global economic growth is accelerating. Just last week the IMF raised its global growth forecast from 3.1% to 3.5%. According to the IEA s latest five-year oil market forecast, there could be a steep increase in the price of crude oil by But if world demand accelerates this year, as we think it might, energy could be in short supply by as early as this summer. Because the US is still the number one consumer in the world, even though China and India are coming along, President Trump s promise to increase GDP growth from 1.5% to 3-4% will have a powerful impact on energy consumption and could contribute to a demand-shock. Accordingly, MRP is sticking with the long energy theme. Strong global demand in the face of a contraction in supply should boost crude oil prices to the $60-$80 range. The entire energy sector of the stock market would rise accordingly. However, the Trump administration s stated vision to unleash America's $50 trillion in untapped shale oil and natural gas reserves, in its quest for U.S. energy independence, would also mean significant new business for the oil service industry and companies such as those in the VanEck Vectors Oil Services ETF (OIH). Indeed, President Trump just signed an executive order aimed at expanding offshore oil and gas drilling in the Arctic and Atlantic Oceans, territories which were put off limits by a December 2016 Executive Order by President Obama. For MRP s research disclaimer, please go to