The Global Energy Fund moved moderately higher during the month, helped by a very strong oil price. The outperformance of oil versus the energy sector, with Brent up 7.4%, is now at extreme levels and suggests that the market is very sceptical with regards the durability of the cycle, something we believe offers significant opportunity.
We are rapidly transitioning from a market drowning with too much stored oil and oversupplied, to one that is now under-stored and undersupplied. The implications for the oil price are bullish and due to the collapse in capital spend, we believe it is going to remain undersupplied for some time to come, which would obviously be bullish for the oil price and the energy sector.
The dislocation between the oil price and sectors is primarily down to the market worries that the recent ramp up in US production is about to drive crude OECD inventories higher. Consequently the market is heavily focused on Q1 inventory reports which is typically the time of the year when we are most likely to witness seasonal inventory builds.
Due to the International Energy Agency report’s two month lag, it is always useful to look at what US inventory figure are telling us, as they report weekly and make up a significant portion of OECD inventories (43%). Only once in the last 30 years have US crude inventories failed to build in the first quarter. Over the last 10 years, that build has averaged 8.4% so a build in the first quarter should certainly be expected. However over the quarter, and past two months, US crude inventories are only up 1.2% - effectively flat. Consequently we are confident that the IEA build numbers for the Q1 are going to be considerably lower than the numbers feared by the market.
It is worth remembering that this anaemic build in US Q1 crude inventories took place despite US crude production increasing by 7%, thanks to record gasoline demand, very robust refinery demand and very strong crude and product export numbers.
As we move through the year US crude production growth is at risk of ‘hitting the skids’. One of the most glaring problems is pipeline capacity. We have already heard reports that a lack of pipeline capacity is beginning to hit some producers, something that will be an increasing problem as production continues to increase. When unconventional onshore oil is produced, associated gases are also produced among them, particularly propane, ethane and butane (Natural Gas Liquids or NGLs). As so much gas is being produced, their prices are very low. Consequently if pipeline capacities are close to ‘full’, producers would rather strip those out by flaring (burning them off) rather than taking up pipeline capacity and piping them with a lower concentration of the higher margin crude oil. However, exploration and production companies are only allowed to flare a certain amount of associated gases and many of the producers are beginning to hit their limits, particularly in the Permian Basin, which is responsible for the lion’s share of production growth. This means that producers are being forced to pipe the crude together with higher concentrations of the NGLs.
Piped crude can only contain a certain percentage of NGLs as it increases the volatility of the liquid so producers are being forced to ‘choke back’ their wells and thereby produce less crude and associated gases. This ‘choke back’ could curtail US production growth, which would clearly be bullish for oil prices.
With the prospect of low inventory and undersupply, risk premium is returning. Trump’s appointment of John Bolton as National Security Advisor and Mike Pompeo as Secretary of State, definitely elevates the chance of a risk premium event occurring. Pompeo and Bolton are known for their predisposition to favour aggressive military action and were both heavy critics of the lifting of Iranian sanctions, a policy that Trump clearly wants to reverse.
If Trump is successful in conveying a rhetoric that encourages Europe to join the re-imposition of sanctions on Iran, then we could see up to 1.5Mbbls of supply removed from the market. As the Syrian tragedy escalates, that rhetoric is being unfurled and we are beginning to see a global hardening stance against the Iranian/Russian backed assistance of the Assad regime. The re-imposition of sanctions in May, backed by Europe, looks increasingly likely. Trump will expect backing from the UK, particularly following the US’s unexpectedly strong supportive expulsion of 60 Russian diplomats from the US, following the nerve agent attack in Salisbury.
The Fund has retained its high oil price sensitivity at almost 1.4, increasing exploration and production (E&P) exposure but cutting shipping stocks, switching from a low oil price sensitive sub-sector to a high. We feel that there is greater valuation upside in E&Ps, and signs that improved capital discipline will help the markets perception of the sector.
We are moving towards a market that will increasingly rely on the growth in US production which accounts for 7% of total supply and the need to see an improvement in the supply outlook for offshore production which is more than 30% production, in order to meet strong oil demand. Consequently the combination of improved pricing and volume of work is likely to benefit a raft of sub-sectors within the oil sector.
While the major oil companies were struggling to even cover their capital expenditure, let alone their dividend, using organic cash flow in 2013, when Brent was over US$110bbl, they have cut significant costs and made significant disposals, so that their businesses now cover their capex while paying covered dividends at US$50bbl.
With the positive outlook for the oil price unfolding over the next few years, integrated oil companies beginning to show significant cash balances and industry reserve replacement ratios (RRRs) looking increasingly challenged entering into the 2020s. We believe capex in the offshore space is poised to follow the turn in onshore spend higher as these projects take at least 3-7 years from the point of sign off.
In our opinion the weighting of energy stocks within the MSCI World Index is very close to an all-time low, a clear indicator when combined with fundamental work that the cycle is due for a turn.
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