Saudi Arabia reduced exports to the US now that mid-terms are over.
- Oil experienced its worst month in a decade.
- US production growth is unexpectedly strong.
- Saudi Arabia continued to export the vast majority of their production ramp to the US, until the week after the mid-terms.
- US President Trump surprised the market with eight temporary waivers to the US sanctions on Iran.
- We await the result of the OPEC meeting, where cuts are expected.
November was a tough month for the energy market as oil suffered its biggest monthly decline in a decade. A confluence of growing US supply growth, Iranian waivers, crude exports from Saudi Arabia and hedge unwinds destroyed sentiment. The recent jump in US production tipped a market that was already worried about building US inventories over the edge.
The Fund suffered from too-high an exposure to exploration and production (E&P) companies and drilling. Over the month refiners were reduced and moved into the integrated oil and gas companies. The market is becoming increasingly nervous and appears more willing to invest in the integrated oil and gas companies as a first step into rebuilding weightings within the sector when sentiment turns.
As we wrote last month, the reason why US inventories have built over the last three months is because Saudi Arabia diverted 70% of its production increase to the US, thanks to discounted pricing. This production increase was unsustainable as it consumed most of Saudi Arabia’s spare capacity and took their inventory cover from seven to ten year lows. We felt that shipments would normalise and that the longer-term dynamic would not be affected, thus we maintained our high oil price sensitivity. Although US inventories did temporarily build, the market focused on the fact that, as we believed, Saudi Arabia were running out of spare capacity. What ‘spooked’ the market was the fact that US President Trump issued eight waivers for Iranian exports just ahead of the US mid-terms, in a bid to get oil prices down for his electorate. These events culminated in the oil price sell-off, which was rumoured to be further exacerbated by a significant hedge/trade book unwind, which was allegedly long oil, short gas.
What has transpired since those November lows? Firstly, Saudi Arabia has already dramatically reduced exports to the US and since mid-November we have seen a halving of Saudi imports of landed crude, something that has helped shift US inventories from a pattern of building to what we believe will be a draw in December. The market is focusing on OECD inventories and it will be more financially beneficial to ship their crude to the less focused on non-OECD areas (non-OECD inventory builds have a lower oil price elasticity). Saudi Arabia have now cut production, under the guise of an OPEC cut, thereby recovering some much needed spare capacity. These factors could go some way to repairing the damage done and we firmly believe that we will see a bounce in the oil market, in the absence of a market sell off due to recessionary fears.
The market has, during early December seen a significant removal of oil supply from the market. OPEC have now cut 1.2Mbbld, Alberta have also been forced to reduce supply by 325kbbld due to pipeline constraints that will not be solved any time soon. Additionally, a recent outage from Libya has removed a further 385kbbld; we know supply from Libya is not reliable. Consequently, the market has lost 1.9 million barrels of supply over the last week, certainly enough to allay any short-term fears of over-supply. The oil price correction could not have come at a more sensitive time to influence 2019 US supply. The end of the year is the time when budgets are set by US E&P companies and the recent move will, in all likelihood, have had an impact on US production levels. It has been these US production levels that have also been partly responsible for the sharp turn in sentiment, and perhaps it will be data released that US production growth is turning lower that will help to turn data again, more positively. In the short to medium term, we believe that we are going to see a decline in US production growth beginning in Q4 and running through to Q3 2019, due to a confluence of issues including pipeline constraints, budget exhaustion and oil price affected budgetary spend.
With regards the move by Trump to allow eight countries to have waivers allowing the import of Iranian crude, a move that appeared to be the straw that broke the market, we don’t believe that they will be as effective as the market fears. Japan and North Korea are having issues obtaining insurance for the vessels carrying Iranian oil. Greece and Italy stated that, having arranged for alternative suppliers, they are unwilling to reverse and jeopardise those deals in favour of an Iranian supply that will only last six months. Countries like China will be keen to reduce their reliance on Iranian crude, thereby removing any additional leverage open to the US during trade discussions. Although sentiment has certainly taken quite a hit, we do see evidence that data points will begin to move in its favour, and when they do we expect sentiment to turn and oil prices to rally.