2018 brought with it some exceptional challenges which came to a head in Q4. The quarter witnessed one of the most extreme swings in sentiment that we have seen in decades.
In March 2018, Saudi Arabia began to discount oil to the US, which encouraged the doubling of their exports to the region between February and August, as a way to offset the loss of future Iranian oil supply and control prices going into the US mid-term elections. The market shrugged off the building US inventories due to the fact that they believed Saudi’s move was unsustainable. In order to facilitate the export hike, Saudi dipped into already anaemic spare capacity and inventories that stood at seven-year lows. Consequently, the price per barrel rose into the mid-eighties, accelerating as the US mid-terms approached. A high oil price was the last thing that Trump needed going into a highly contested battle with the democrats for the mid-term election. Trump attempted to counteract supply concerns that arose when he announced the imminent re-introduction and total ban of Iranian oil exports by issuing eight waivers to countries that were heavy users of Iranian oil. The market saw this as a 1-1.3Mbbld injection of supply, something that rendered worries over spare capacity irrelevant. At the same time US production numbers spiked, spurred by a much needed completion of a pipeline which unlocked logistical bottlenecks. The culmination of these events led to a rapid deterioration of oil fundamentals.
A dent to the oil cycle?
Whilst there has been cause for concern, we don’t believe that this is more than a temporary correction and that the correction has been over-done.
There are several indicators that lead us to believe that in the short to medium-term, we are going to see a decline in US production growth beginning in Q4 and running through to Q3 2019. US Department of Energy (DOE) production figures already point to a plateauing of production growth starting in early November, due to a confluence of issues including pipeline constraints, budget exhaustion and oil price affected budgetary spend. Consensus estimates still predict a continuation of the strong growth in the period. North America is also facing a significant production setback from Canada. At the beginning of December, the Canadian province of Alberta, announced a 325kbbld cut to production due to logistical constraints. At the same time the market received a 1.2Mbbld cut from OPEC. We are seeing many supply adjustments that are simultaneously transitioning through the market, making us a lot more positive with regards to the evolving market balance over 2019.
The Fund reduced its oil price sensitivity over the quarter by switching 8% of its high oil price-sensitive holdings to less sensitive integrated oil companies. However, it was still hit by the oil price moving 40% lower.
With the implementation of IMO2020 in 2019, the law that requires vessels to use less sulphur in their fuel, we have skewed our E&P focus to companies who own acreage and produce from fields with lower API gravity oil which, when refined, produces a higher ratio of diesel than gasoline (explained below).
We believe that markets will continue to display signs of tightness feared during much of 2018 and that inventories will drop below the five year average before Q2 2019.
As we move through 2019, it will be increasingly difficult to ignore crude quality when trying to determine where the overall oil price is headed, particularly as we head closer to the implementation of IMO2020. Oil supply growth is emanating from light (low gravity) US shale oil. US shale oil, when refined, produces twice as much gasoline but almost half as much distillate (including diesel) than an equivalent barrel of (lower gravity) Brent oil. We have, even before the effects of IMO2020 are felt, seen a progressively tight distillate market and a looser gasoline market. The spread between diesel and gasoline prices have only been this high a couple of times in the last ten years. This divergence in prices is likely to continue widening; refineries will begin to build distillate inventories in H119 in order to meet the demand of 97% of the fleet switching to diesel in H219. This is one of the reasons why we have skewed our E&P focus to higher gravity crudes.
The fuel that ships will be switching away from (residual fuel oil) will need to find another market and will price lower until it backs out substitutes (likely to be the power market, backing out coal/gas) – consequently we could see a big demand surprise towards the end of 2019 and going into 2020. One refiner that we spoke to earlier this year envisaged a 2Mbbld demand spike emanating from this effect. If we happen to see just half of this amount of additional demand growth, the market could be much tighter than forecast.
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