Summary

• Oil price was weak during the month, finishing 7% lower at the end of July
• Trade tensions are still putting downward pressure on the oil price
• Spare capacity remains a hot topic
• Bottlenecks in the US are having a detrimental effect on the price of oil coming out of the Permian Basin.

Fund activity

The oil price struggled this month, finishing lower by 7.03%. Consequently, the high oil price sensitive sub sectors struggled to perform. The benchmark moved modestly higher, following on from a strong Q2. Due largely to its skew to higher oil price sensitive stocks, the Fund suffered and underperformed the benchmark. During the month the Fund moved its weighting in refiners higher by 6% and its holdings in offshore service companies by 4% (funded by decreases in integrated oil companies, shipping and drilling). IMO2020, as explained the last quarterly here, offers a structural boost to refiners that are better equipped to take a variety of crude inputs.  

Market update

A continuation of Trumps heated rhetoric and tariffs regarding world trade weighed on the oil price and masked the continuation of strong fundamental developments. Entering the period between the announcement of the reintroduction of Iranian sanctions and the actual removal of those barrels, the market was prone to a bluff and bluster set back. Trump provides the market with a lot of noise and it is probably more fruitful to examine US actions, as opposed to Trump’s words. Fundamentally his actions have damaged future global supply – Iranian supply is being removed from the market. Trump is now actively engaged in trying to divert blame for high oil prices onto OPEC. Trump does not want higher oil prices going into the mid-term US elections. Consequently, with few fundamental levers at his disposal, he is resorting to rhetoric.  One lever that he feels is at his disposal is spare capacity. However, few are clear as to how much spare capacity the market actually holds; if Trump has his way, we are about to find out. The US President is publically castigating Saudi Arabia for holding back spare capacity and is demanding that it repays the US for its tough Iranian stance (potentially with a desire to invoke regime change) by supplying more oil, at least until the mid-terms are over.

By calling on Saudi Arabia to place all of its spare capacity onto the market, the market will know whether the emperor is wearing any clothes – Saudi Arabia’s power lies not in the oil it produces but in the oil it doesn’t produce.  If Saudi Arabia is shown to have lost its mantle as swing producer at a time when oil inventories are low, the risk premium will elevate. Probably the most telling action over the month was the Saudi assertion that, following its increase of exports in July (out of storage), at Trump’s behest, its export will drop 100kbbld in August, something that calls into question Saudi Arabia’s  purported ability to raise production by 1 to 2Mbbld in short order.  A rise of supply by circa 2Mbbld is something the market believed would be needed in order to balance the market.  Saudi Arabia is also adopting an interesting strategy in the shipping lanes around Yemen. Two Saudi tankers were recently hit by Houthi missiles in the Bab El Mandeb Strait, fired from Yemen. Consequently, Saudi Arabia has just stated (along with Kuwait) that it would not send ships across this shipping channel. The Bab el Mandeb Strait links the Red Sea with the Gulf of Aden and allows ships from Saudi Arabia’s oil laden East coast quicker access to Europe, enabling them to sail around Oman and Yemen, through the Suez canal and into the Mediterranean, rather than having to round the African Cape. Although Saudi Arabia only exports about 10% of its oil to Europe, almost 5Mbbld in total pass through these Straits. Consequently, keeping the channel open is extremely important to the global energy markets. By choosing to stop their ships passing through the Strait, the Saudis are essentially elevating their war with the Houthis in Yemen (i.e. the Iranians) onto the international stage. It also potentially provides a pretext as to why they could not raise production sufficiently to the levels that the US have been requesting and why they couldn’t replace Iranian barrels that are having to exit European markets (Iranian exports to Europe reportedly dropped byhalved in June to just 300kbbld).

Outlook

US bottlenecks continue to constrain the price of oil coming out of the prolific Permian basin, spreads between Brent and Permian have continued to widen, meaning that Exploration and Production companies in the basin are being forced to take a US$21bbl discount to Brent (unless they have either their own takeaway capacity).

Supply is therefore struggling to keep pace with the market and it increasingly looks as though inventories will continue to draw. Longer term supply is also, in all likelihood, going to take a 1 to 2Mbbld hit from IMO2020 regulations affecting the shipping market. Shipping companies will be forced to buy more middle distillates (modified diesels), leading to less productive refiners globally (the elevated middle distillate prices will encourage refiners to run less efficient slates). The price of high sulphur fuel oil will likely move down to where it’s next market lies (used in asphalts for roads or to a level of pricing where it competes with coal as an input for power stations). Consequently, demand may move higher as well (power has not been a growing market for crude derivatives since the 1970s).