Oil is setting up for a monster rally

Bank of America Merrill Lynch is bullish on the energy sector again.

In a note on Tuesday, Savita Subramanian, the head of US equity and quant strategy at BAML, said the bank upgraded the sector to “Overweight” from “Market weight,” with the expectation that it will outperform the S&P 500.

“Our commodity strategists estimate that most of the sell-off in oil prices is behind us, as they look for WTI oil prices to rally to $54/bbl (+17%) by the end of the year and $69/bbl (+49%) by next June,” Subramanian wrote to clients.

“Oil production continues to fall, as global oil & gas investment has been cut by nearly $300bn (41%) and rig counts have dropped by 37% since the 2014 peak. In contrast, low oil prices continue to drive healthy demand growth, putting the oil market on pace to see its biggest supply-demand deficit since 2011.”

But there’s still no consensus on the timing of the oil market’s rebalancing more than two years after prices came crashing down amid a supply glut.

Earlier on Tuesday, the International Energy Agency — a global watchdog — cut its forecast for oil demand growth this year in its monthly Oil Market Report. It now expects the oil market to rebalance in 2017, but its previous predictions had pointed to the end of 2016.

At the same time, the points that BAML made above, including the slowdown in capital spending, is attracting some investors back to the sector.

The largest oilfield services companies indicated during their last earnings calls that they were renegotiating prices with drillers. The fact that they’re doing this, rather than aggressively cutting prices to attract customers, is considered a bullish signal.

Also, around mid-August, hedge funds and other money managers made a weekly record high increase in their net long position — the surplus of bets for a price increase over bets for a fall — in the main oil futures contracts.

Subramanian noted that the energy sector is still the fourth most underweighted on the S&P 500, and the worst performer relative to the benchmark index since 2009. This dropped its share of the S&P 500 to the lowest in nearly a decade.

However, “there has never been a time when the energy sector’s weight has dropped below 7% and the sector did not outperform the market over the subsequent three years.”

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