Summary

• The Fund had a strong month and outperformed the benchmark as brent crude finished the month 7.5%. Crude demand has been surprisingly strong - Q2 saw its second strongest period of crude demand in seven years.
• Fundamentals continue to improve, despite data volatility, due to Hurricane Harvey and Irma.
• US gasoline and distillate inventories are now at a five year low and at five year average levels (respectively) – the market is tightening at a fast pace.
• Geo-political risk has elevated (Libya, Kurdistan and Iran).
• Equities have not kept pace with the oil price – we think this will change as fears over the pace of US supply growth abate (thanks to various production bottlenecks).

High oil price sensitive sectors performed well

The Fund garnered most of its outperformance from the high oil price sensitivity sectors of drilling, equipment, service and exploration and production companies (in that order). The Fund did not make any significant changes during the period.

Fundamentals continue to improve and geo-political risks elevate

Strong OPEC compliance (107%) and strong demand have meant that inventories continue to rebalance at a faster rate than the market anticipated only a few months ago. We are entering a period when, typically, OPEC exports begin to elevate, but note that floating storage in the Arabian Gulf and Saudi storage of crude are at multiyear lows, implying limited capacity to augment export figures from reduced production (however this factor is somewhat offset by a build in floating storage in the US Gulf coast as a consequence of the recent hurricanes affecting off loadings). Saudi appears to hold significantly lower inventories than the norm and continue to reaffirm their desire to limit export growth, particularly to the US (where most of the focus still lies).

Inventory in gasoline is now at a five year low and distillates are 6% below their five year averagelevels (ahead of a period that normally sees material inventory draws). Almost every key product is now in backwardation (futures curve is below spot, indicating tightness). Demand has also been surprising to the upside and IEA estimates continue to be readjusted higher (300kbbld stronger than anticipated at the beginning of the year), in fact, Q2 was the second strongest period of demand growth for crude oil since 2010. Consequently markets are a lot tighter than the recent price action was telling us they would be at this point in time. We also note that geopolitical risks have begun to elevate; Kurdistan vote for independence, Iranian nuclear agreement looks to be in jeopardy and Libya’s production volatility is back. The recent price recovery has, in our opinion, been fundamentally justified. 

Equities have not kept pace with the oil price – we think this will change

Although the sector had a strong performance during September,the energy equities have not kept pace with the oil price recovery due to fears of oversupply in 2018, particularly driven by the fear of US production overshooting. However, it is becoming increasingly evident that the US onshore faces certain bottlenecks over the short/medium term – most notably in pressure pump availability and potential delays in localised sand production due to sand mining license applications hitting snags and issues regarding an ‘almost’ endangered sage brush lizard (for more information please see our quarterly) are proving to be a potential issue. If sand volumes are not increased we could see a delay in completions impacting supply of US crude.

These are a couple of reasons why we believe that we could see a flatter cadence of activity through YE’18, as the pace in activity over the last 12 months has resulted in inefficiencies across the upstream value-chain. While we believe that these inefficiencies will be transitory, we still anticipate a less accelerated pace of completions, something that will obviously tighten inventories faster than anticipated and allay some of the oversupply fears being baked into the market for 2018. As fears over the pace of US supply abate, we believe that energy focused equities will close the performance gap versus the oil price recovery.