The Fund was helped higher by the continuation of the climb in crude prices. Brent crude rose 3.7% to US$68.9bbl, but West Texas crude (WTI) rose 7.13% to US$64.7bbl, thereby narrowing its steep discount to Brent.
The areas that performed well included the high oil price sensitive sub sectors of drilling and E&P. Also performing well was industrial machinery; a sub sector which includes two capital equipment fabricators that supply into the fracking companies. Underperforming areas this month included the low oil price sensitive sub-sectors and some of the companies exposed to electric vehicles, which we had reduced.
The latest (November) IEA (International Energy Agency report, showed further evidence that crude inventories have continued their rapid descent, declining for a fourth straight month by 17.9Mbbls. However the organisation pointed to the likelihood that forecast December inventories fell by a further 42.7Mbbls, which would mean that OECD Inventories are, on a ‘days of forward demand cover’ basis, only 1.4% away from being fully normalised.
Globally, storage is now lower than historical norms; some fairly large financial institutions are beginning to agree with the fact that OPEC are now ‘behind the curve’ with regards when they should begin to relax their production cuts. By continuing with the supply cut, we believe OPEC is looking to create an ‘inventory fairway’ that will accommodate both the aggressive US growth and the return of Saudi oil without driving inventories above normalised levels and hence, without jeopardising prices. This helps to explain the confluence in the seemingly confused Saudi rhetoric when they allude to the fact that the market needs to focus on ‘days of forward demand’ (which points to a low storage situation) in some of their rhetoric, whilst still insisting that they and Russia need to prolong their production restraint until the end of the year and possibly into next.
Until this ‘fairway’ opens up though, the market will continue to focus on the rate of supply growth emanating from the US onshore. November’s US production number was strong, particularly from the Permian basin, and as such requires monitoring. The IEA expect US production to grow by 1.35Mbbld; an exceedingly tight upstream value chain, potential infrastructure bottlenecks (especially across W. Texas/SE. New Mexico, Colorado, and North Dakota), and more reasonable E&P capital allocations (the rhetoric from Q4 reporting, so far, confirms that this remains a priority, despite higher oil prices) all mean that reaching that level of growth could prove to be very challenging. Many of the E&P companies have stated that they will use the additional cash flow to pay down debt, following years of budget overspend.
Offsetting a sizeable chunk of US supply growth, are areas such as Norway and Venezuela. Norway has now entered into a period of sizeable production decline of -257kbbld year on year in December; this decline which will persist until Johan Sverdrup comes on stream in 2020. Venezuelan production is now in ‘free fall’, with production declines now accelerating. December production fell 490kbbld year on year. Crude shipments to the US are now down to c.300kbbld, down from the typical 800kbbld seen in the 2013-2017 period. There were 50 rigs working in Venezuela in December; industry sources speculate that the country requires 100 active rigs to be drilling in order just to halt the decline.
With regards to demand, the IEA expect this year to be a year of consolidated growth (dropping from +1.5Mbbld in 2017 to an expected growth of +1.3bbld in 2018), the delta being held lower by higher prices. However, the IEA are notoriously conservative with regards demand; on average the IEA has, since 2014, under-cooked their annual demand expectations by a sizeable 700kbbld. We believe that 2018 could be another year when the IEA raise their expectations, as demand is more elastic to the change in medium to long-term price trend changes, as opposed to short term changes. Hence the price correction from the US$100+, during the 2011-2014 era, to the sub US$70bbl prices now is still eliciting a positive economic effect in many countries that were net consumers of oil.
The positive economic effects of reduced energy subsidies in non-OECD economies, where energy subsidies are more prevalent, take time to transition through economies, and are still, in all likelihood, being felt. In addition to this, consumer behaviour (vehicle choice, housing location etc.) and industry behaviour (choice of suppliers/switching in materials etc.) take time to react, consequently the oil price move over the last six months is not likely to have a consequential effect on consumption behaviour. On the other hand, the synchronised global expansion that is currently being experienced is more likely to have had an over-riding positive effect on the delta of global demand. Hence, we believe global demand could prove to be rather stronger than the IEA expectations and possibly stronger than last year’s demand growth.
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