Summary

• The Brent crude oil price finished the month over 7% higher, leading to the highest price in three years.
• We retained an oil price sensitivity of 1.4 v the benchmark and attained most of our outperformance from sub sector allocation decisions.
• A cracked pipeline in the North Sea and Iranian protests lead to a return of risk premium.

Market update

The Brent crude oil price finished the month over 7% higher resulting in a strong month for the Fund outperforming its benchmark. We retained an oil price sensitivity of 1.4 v the benchmark and attained most of our outperformance from sub sector allocation decisions. We retain an overweight stance in high oil price sensitive areas such services, exploration and production (E&P) and an underweight in low oil price sensitive areas like integrated oil companies Shell. Two of the major contributors to performance emanated from lithium miner Nemaska, infrastructure developer Golar LNG and Solaris who build and operate sand storage for onshore US oil and gas producers. Permian basin focused E&P companies Diamondback and RSP Permian also performed well.    

2017 has been a frustrating year and one that was clearly split into two halves.  The Fund was positioned for strengthening fundamentals and an oil price that would end the year in strongly positive territory near US$60bbl. Our expectations were met, however the market proved reluctant to react. It took the oil price until the end of June to react to the rapidly improving fundamentals, (rebounding 45% since then, but it took the stock market until the end of August to start its ascent.

Outlook

We are now entering 2018 in a far healthier state than we exited 2016. Oil markets are undersupplied, even with OPEC cuts still in place, and inventories are far lower than where we started 2017. In fact, anecdotal evidence points to a global inventory market that has arguably already balanced.

The combination of more balanced inventories, the low number of projects delivering first oil between 2019-2021, years of slashed maintenance spend and empty government coffers in producing countries will likely lead to the return of risk premium on the price of oil. As the year progresses, the oil price will become increasingly sensitive to any supply disruption.

We should also be cognisant of the fact that we are moving into a period whereby these disruptions are increasingly likely. Equipment has not been maintained and the chances of civil unrest in petro-economies are high even as budgets recover. The adverse reactions of both are often most keenly affected by duration of underspend, not just quantity of underspend.

During the month we saw a couple of examples of how risk premium is returning. In mid-December, the energy market lost 400kbbld oil production in the North Sea, due to a cracked pipeline. The 235 mile Forties pipeline, which links the UK and the North Sea carries circa 40% of the physical oil in the Dated Brent benchmark. The shutdown, was responsible for an immediate move of US$2-3 and lasted three weeks, consequently driving up other oil grades as buyers searched for alternatives to feed their refineries. The repairs were undertaken by INEOS, who bought the pipeline from BP 6 weeks prior to the incident. The cause of the crack is being investigated and one of the issues that the investigators will be looking at is maintenance.

Towards the end of the month, protests in Iran put further upward pressure on the oil price, sending it to three year highs. Many Iranians believed that the backing of the more moderate Rouhani combined with the lifting of nuclear sanctions would bring a period of improving and freer lifestyle. Those hopes have not been met. Growing resentment to the routine corruption, continued religious ideological oppression and economic mismanagement is threatening the current regime. The geographic and demographic scope of the protests are what makes this particular uprising so threatening for the Iranian regime.  The Sunni/Shia balance of power within the Middle East has rarely been so precarious. Not only is an external battle between the Saudi led-Sunni and Iran led-Shia being fought across the Middle East, both of the diametrically opposed religious hegemonies are now being threatened from within

The US spotlight is firmly fixed on Iran.  The US seem to be firmly behind the ‘speculated’ Saudi-Israeli alliance, stoking the flames under the Sunni/Shia cauldron, looking for a reason to re-impose sanctions and banning Iranian crude exports. Although the US could do this relatively swiftly, US only sanctions will appear impotent. In order to carry any weight the US will want to move under a pretext that will garner support from Europe et al. This will be a tough task as many European countries do not want to be too closely associated with an overtly aggressive foreign policy that is prone to change with a tweet.  If sanctions do return, particularly with the support of the Europeans, then we can expect an even tighter oil market and higher price than currently being envisioned.