Summary

• Oil prices rose almost 14% on the month
• Iran sanctions are re-imposed by the USA (likely to affect most International transactions)
• Venezuela, Libya, Nigeria, Mexico and Angola all struggle with declining production
• OPEC agrees to raise production, but is unlikely to be able to counter the decline in supply
• US production hits bottleneck issues, jeopardising the future rate of production growth

Fund performance

The Fund had a strong quarter, finishing up 13.7% and outperforming the benchmark by 1.7%. Most outperformance came from the high oil price sensitive sub sectors (drilling, exploration and production and services). The Fund’s move away from Permian producers was rewarded as infrastructure bottlenecks threatened to drive a climbing Permian (Midland) crude discount to Brent. Consequently, exploration and production companies outside of the Permian basin outperformed. The spread between Midland and Brent blew out from US$1.8bbl to over US$20bbbl. While the price for Brent crude has rallied by over 20%, Midland crude has only moved 1.5% higher, year to date. This bottlenecking of Midland crude has made us less optimistic with regards the cadence of US supply growth. Permian crude has contributed to approximately 80% of US supply growth. It is now likely that the pace of US supply growth will begin to slow in the second half of the year, something that is bullish for oil macros in general.

Market update

June was a tumultuous month for the energy sector. Most of it was spent waiting for the 22 June OPEC meeting, a period that is normally filled with noise, wild speculation and extreme volatility; this time around, the market also had to contend with the tub thumping of US President Donald Trump, who vacillated from wanting to break OPEC apart, to calling upon it to increase supply in support of his re-imposition of sanctions on what he said was “OPEC’s greatest enemy – Iran”, forgetting that Iran is, of course, a member of OPEC!  It appears that Saudi Arabia probably has an understanding with Trump to raise production in return for a strict enforcement of Iranian sanctions.  Hence Saudi performed an ‘about turn’ in response to Trump’s various tweets and switched to a ‘pro-raise’ stance, much to the consternation of the majority of OPEC nations who cannot even meet current quotas and has zero ability to benefit from a production increase. This divergence of opinion had the potential of creating a significant split within OPEC. Saudi Arabia managed to square the circle with an agreement to raise production, but declined to define by how much.

Outlook

When debating the quantum that Saudi Arabia should increase by, it is noteworthy that two of the primary price drivers of oil, inventory levels and spare capacity, are inextricably linked.  Inventories have been falling at an alarming rate, thanks to undersupply in the market, and art now below normalised levels. The resolution to the undersupply issue requires the pull of spare capacity into the market. One exacerbates the other, robbing Peter to pay Paul. Spare capacity is currently at very low levels, and currently sits below 2Mbbld, if measured by the strict International Energy Agency (IEA) definition. If Saudi Arabia were to commit just 1Mbbld of its spare capacity back into the market, spare capacity would fall to levels very rarely seen (with some analysts suggesting that spare capacity will soon be at the lowest level seen in 100 years)

The market is currently having to contend with a litany of oil producing countries struggling with production (including Venezuela, Libya, Iran, Nigeria, Angola, Kazakhstan, Mexico and Canada), this is all happening at a time of the year when demand seasonally increases by c.1Mbbld. The volume of losses being experienced is creating a supply gap that is increasingly difficult to fill, even with a commitment of remaining Saudi spare capacity coming ‘online’. The problem with Trump’s insistence that Saudi Arabia brings on all its spare capacity is that a Saudi supply hike to above 12Mbbld would take considerable time (probably over a year) and would leave the market with essentially zero spare capacity, therefore highly susceptible to price spikes and a price that will trade with an extremely high risk premium. If the policy is successful in pulling down the oil price, then it will delay the sign off of essential supply projects, creating a shortfall that will only be exacerbated over time. If the objective is to tide adequate supply until US shale oil infrastructure can be delivered (Q4 2019 to Q1 2020), then there is still an issue. The very ‘light’ characteristic of US oil is a problem. Light oil does not provide the same quantum of middle distillates (jet fuel, heating kerosene, gas and diesel oils) that heavier crudes that are declining in volume do. It is these middle distillates that the market is becoming increasingly short of – particularly in the face of the introduction of the IMO2020 regulation being introduced for the shipping industry in 2020 (which will create a spike in demand for diesel). We cannot get around the problem that the oil market needs a price that drives more supply, any attempt at circumventing this smacks of little orange fingers being stuck in the holes of big dykes!