Going into the US mid-terms, the oil market had a significant wave of bearish news this month and subsequently the price of crude declined 11%. The Fund underperformed the benchmark due to its higher oil price sensitivity, losing most of its alpha because of the allocation towards more sensitive oil price sub-sectors. However, much of the bearish news that the commodity faced can actually be put down to timing. We believe US President Donald Trump feels the need to win the mid-terms and doesn’t care how he does, the end justifying the means for him. In some of this apparent bearish news we can see some very positive seeds being sown. For example the release of waivers to eight countries that import significant amounts of Iranian crude was seen by the market as a bearish move, as it puts more oil back in the market. However, if we examine why this has been done it points to a very bullish indication that there is very little spare capacity in the market.
Trump appears to have wanted to go into the mid-terms with an unwavering stance versus Iran, with Saudi and Russia making up for the shortfall, and a lower oil price. He has managed to get Saudi to produce more oil, but Saudi’s oil production numbers were up and their storage (measured in terms of days of forward supply cover) is now at the lowest level in ten years so they are probably reluctant ‘over suppliers’. Consequently, Saudi’s oil in transit has fallen over 15% since the first week of October. It takes about 35 days for Saudi oil to ship across to China. It could be argued that they have pushed out what they need in order to help oil prices lower for Trump’s mid-terms. We think Trump will be far less concerned about high oil prices once the mid-terms are over. It is also interesting that there is now talk of a further OPEC cut in their upcoming meeting (Saudi will be keen to wrestle back some of that spare capacity and use any excuse to intimate that their reduction in supply is a controlled pull back, as opposed to an enforced cut back).
The demand outlook is increasingly ‘under the microscope’ and what is giving fuel to the bear argument is the IEA’s expectations of a significant drop off of oil demand, particularly in the first quarter 2019. We disagree with this forecast for a number of reasons. Firstly the IEA has form when it comes to underestimating demand forecasts. As we wrote at the beginning of the year, “the IEA are notoriously conservative with regards to demand, over the last two years the IEA have increased their demand expectations 25 times, whilst they lowered them only 10 times. 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”.
We can see how this tendency to underestimate demand plays out if we take a year like 2017 in isolation. The forecast for 2017 demand, made in 2016 was 97.5mbbld. In total, the IEA underestimated 2017 demand by 380kbbld or 33%. Relative to their previous margin of error of 700kbbld they have improved, but a swing of 380kbbld represents the difference between inventories staying flat and drawing by almost 140mbbld, and according to some estimates represents more than half of the total spare capacity that will available to markets in 2019. Looking forward to 2019, we believe the IEA’s expectations that demand in Q1 2019 will drop to 98.95mbbld, from 100.15mbbld in Q4 is deeply conservative. The implication for getting supply and demand models wrong in 2017 versus getting forecasts wrong in 2019 is also important to consider. Since Q1 2017 the OECD has reduced its industrial inventories by some 200 million barrels and is now carrying c.34mbbls less than a normalised average. Possibly more importantly, the world has half of the spare capacity available to it, so the market is significantly tighter and is also carrying the lowest level of spare capacity in 14 years. This will move lower as Iranian sanctions hit the market and Saudi et al. use their limited spare capacity to replace that crude. The miscalculation, in our opinion, of demand expectations in Q1 2019 will not be hidden by these supply cushions as it would have been in 2017. What the market is worried about is a return to over-supply, particularly in Q1 and Q2 of 2019. We should remember that seasonality trends normally point to an over-supply in the first half of 2019 and, as discussed above, we don’t believe that it will be as over supplied as the IEA expects. The IEA anticipates that the oversupply will be outsized versus seasonal norms – we do not. We believe it will be within the seasonal norms of c.300kbbld, with a significant chance that outages could send that over supply to under supply.
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