The energy market retreated from its positive start to the year, falling almost 10%. The Fund performed slightly better, but still fell -8.7% while Brent crude oil fell 5.6%. Most of the Fund’s outperformance emanated from an overweight allocation to the storage and transportation sector with an overweight allocation to shipping which was helped most notably by Golar LNG. Golar LNG updated the market on its progress with its inaugural floating liquefied natural gas facility (FLNG) off the coast of Cameroon. The unit, named “Hilli”, is on track to produce its first LNG within days. As this project de-risks, it is anticipated that orders will accelerate.
The individual stocks that performed well included Cactus, a newly-listed onshore oil services company, as well as Diamondback and Energen, both Permian Basin focused exploration and production (E&P) companies.
OECD inventories fell 56Mbbls, the sharpest monthly fall since February 2011. OECD inventories are now just 52Mbbls above the five year average – the lowest divergence from the five year average since November 2014 when oil was US$90bbl. The International Energy Agency (IEA) once again started adjusting their yearly demand expectations higher. As we pointed out last month, they are historically very conservative with their start of year demand predictions - since 2014 they have ‘under cooked’ their annual supply expectations by 700kbbld on average. This year they have made their first revision after just one month, upping 2018 expectations by 100kbbld to 1.4Mbbld growth.
The market is faced with two overriding dynamics pulling and pushing sentiment at the moment. Since the end of August 2017, the energy benchmark has risen almost 9% while the Fund has appreciated just over 18%. This has been driven by a contraction in global crude inventories from an unprecedented overstorage situation to a normalised/understored situation depending on the definition of ‘normalised’. However, as the fundamentals improved, the oil price moved 27% higher with Brent crude clearing the US$70 mark at the end of January. This oil price appreciation has driven US land activity and consequently, US production higher.
Since the end of August US production has grown c.750kbbld of which 76% comes from the Permian Basin. This move has caused concern that the US will create an oversupply in the market. Concern has been piqued as the result of the US production acceleration since January as markets are often prone to extrapolate. Consequently, from the recent peaks the oil price has corrected 7.5% and the energy sector has given up 12%.
The fundamental question therefore is this – is it correct to extrapolate the recent acceleration in activity and consequent US land production?
This was one of the primary issues we examined while on a recent tour of the Permian Basin. Understanding the cyclical constraints is critical in formulating a plausible path for US onshore production growth. The overriding message from the companies that we visited was that labour and housing is a significant issue. Access to equipment is also tight and we will see cost inflation. This, coupled with the new E&P mantra to observe capital spend discipline by public companies, i.e. drilling within cash flow and drilling for return on equity, as opposed to drilling for production growth, is likely to result in a slowing pace of production growth – something that is likely to constrain the market from becoming oversupplied.
Although access to frac crews is tight, it appears that access to truckers who move sand used in the fracking process is also heavily constrained, while access to coil tubing crews is even tougher. One company stated that access to experienced coiled tubers is “nigh on impossible!” Service rig handlers are also proving to be very tough to find and this, coupled with the fact that day rates for surface rigs are so low that companies are reluctant to increase salaries and hence reluctant to restart rigs which they may fail to staff. Unemployment in Texas is the lowest it has been on record, so hiring has to come from outside the state.
Here lies the next problem. Schools are full, healthcare delivery is at breaking point and houses are in short supply (there are only 200 houses currently for sale in Midland). Putting workers up in hotels is an option that is tough to pursue, with one company stating that they have been quoted US$1,000 a night for a two star hotel. The market is therefore likely to start to hit some capacity constraints and extrapolating the recent spike in production would be incorrect.
Consequently, we expect a balanced first quarter with regards global supply and demand, moving to a resumption of the undersupply that we saw for most of last year, consequently we expect inventories to resume their path lower. Once we move past this inventory plateau, we expect the energy market to begin to focus on the favourable undersupply/low storage tailwinds that will help the market move higher.
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