• Waivers regarding Iranian crude export restrictions, combined with robust production from Saudi Arabia and the US, has suddenly resulted in a short-term oversupply of crude. Still, we believe the recent pullback has created a buying opportunity as fundamentals remain favorable longer-term for energy equities.
    • Saudi continues to be dependent on high oil prices to fund its government. Thus, we believe it will lead OPEC to take actions supporting prices, similar to two years ago.
    • Due to operational improvements in recent years, low-cost US producers can generate strong cash flows even at prices lower than today. Moreover, many energy companies have adopted shareholder-friendly strategies of returning free cash flow through dividends and share buybacks.


Following a 7% plunge in WTI crude oil on Tuesday, Nov. 13th (the largest since February 2015), we received an email from a technical analyst making the case for playing a bounce in prices.  A bounce?  Is that all we are going to get after a record 12 consecutive down days for oil and a nearly 30% drop in WTI in just over a month?  To energy investors, the idea of just a bounce may seem discouraging, especially as equities in the sector, in our view, never really discounted higher oil prices earlier this year and certainly did not fully factor in short-term forecasts which only recently were calling for pricing approaching triple-digits.

Undoubtedly, the near-term narrative surrounding crude has changed considerably in just a couple months. At that time, the prospects for a surge in oil prices were very realistic.  As discussed in our August 29th note “Oil: It’s About to Get Tight(er) in Here,” this was to be driven primarily by a dramatic reduction in Iranian exports given the full effect of the new US sanctions, as well as further declines in sharply falling Venezuela production.  The offsets at that time were expectations for somewhat lower global demand growth under a stronger USD and a meaningful rise in Saudi output, albeit the latter to be capped by minimal estimated spare capacity among OPEC.  In total, the supply factors were to overwhelm any fallout in demand, leading to significantly higher prices.

Unfortunately for oil bulls, politics has seemed to get in the way. Saudi, already in hot water from the Khashoggi incident, has appeared to appease President Trump even more than expected by cranking up their crude export spigots and doing their part to preempt any rise in fuel prices just before the US election.  (We view this “Pump for Trump” assertion now as closer to fact than conspiracy theory.)  Moreover, despite a previously harsh tone toward Iranian exports, the US Administration has largely softened its stance by issuing six-month waivers to eight countries currently importing Iranian crude.  According to Energy Aspects, the implication now is that an estimated 1.3 million barrels per day (mmbl/d) of Iranian crude exports recently thought to be leaving the market looks likely to stick around.

In the meantime, production in both Saudi Arabia and the US has ramped even above expectations. For the US, the further proliferation of shale drilling resulted in August production figures of 11.3 mmbl/d, up a dramatic 2.1 mmb/d from a year ago.  Similarly, Saudi’s output bounced to 10.7 mmbl/d in October from a tight range of 9.9-10.0 mmbl/d that it maintained from early 2017 to mid-2018.  The net impact of these production ramps and the pushed-back restrictions on Iranian exports is a global crude market that has quickly become oversupplied.

The rapidly-developed oversupply of crude is evidenced not only by the absolute drop in the spot price for Brent and WTI, but particularly in Brent time spreads which illustrate the shape of the forward curve. As shown in the chart below, the sharp drop off in Brent time spreads into negative figures represents a price curve that is in short-term contango (forward prices higher than spot prices) or, in other words, current markets that are very well supplied.  The oversupply has also been evidenced by recently rising inventory levels reported weekly by the US DOE.  Granted, this rise in crude inventories lately is consistent with the seasonal pattern of inventory changes during the fall refinery maintenance period.

It’s not surprising to us that the steady pounding crude prices have taken in recent weeks has brought forth bearish cases that oil is not only going through a short-term correction, but will remain lower for longer. Such a view is supported by the forward curve, which quotes forward years’ Brent and WTI prices substantially lower than the spot rate.  Supporting this price outlook, energy pessimists cite the adverse impacts of a potential break-up of OPEC (unlikely in our view), the runaway train of US production driven by shale fracking, and the US Administration efforts to keep fuel prices affordable (aka Trump tweets).

Despite the altered backdrop to spot crude prices and the current negative sentiment surrounding the group, we believe it is important to maintain perspective on the several factors that are supportive of both crude and energy equities. These points have not changed in recent months and continue to underpin our constructive view of the sector.

    • Saudi still needs high oil prices. Regardless of the Trump pressure to boost its production or its efforts to diversify its economy, Saudi Arabia remains highly dependent on high oil prices. Specifically, in 3Q17 it was estimated by the International Monetary Fund that the Kingdom needs a Brent crude price of at least $70/barrel to balance its economy, a figure that could be even higher today given its enhanced financial needs for military spending and various social programs. As such, we were not surprised by Saudi’s comments last weekend (after the US election) that it would seek to cut OPEC production by 1.0-1.5 mmbl/d to support prices. Still, the real proof of its intentions and ability to dial back OPEC will come with the cartel’s upcoming formal meeting on Dec 6th in Vienna. Some investors have worried that a “do nothing” decision at the meeting (a la November 2014) would lead to another crash in oil prices. Still, given Saudi’s financial motivations and recent experience from the 2014 decision, we view that as unlikely. Rather, a production cut similar to the 1.8mmbl/d cut announced two years ago seems more probable given the global oversupply that has quickly developed.
    •  …although US oil producers don’t necessarily. Contrary to the Saudi government’s need for high crude prices, many US oil producers can perform just fine at lower prices (e.g., a $50/barrel WTI price that many E&Ps use for budgeting purposes). Benefiting from enhanced well efficiencies and new production methods, US shale oil producers in aggregate have substantially lowered their positioning on the global cost curve in recent years. Therefore, even at prices lower than today, many producers can achieve their plans for profitable growth while generating considerable free cash flow.
    • Companies following a new shareholder friendly playbook.Maybe even more significant than the changes the companies have made operationally is the change they’ve made regarding capital spending and returning free cash flow. Over the past year, this new mantra has been exemplified by numerous companies who have reduced capital expenditures and have allocated significant amounts to shareholder dividends or share repurchases. We believe this strategy is not only favorable to current shareholders, but makes the sector more investable over the long-term.
    • Themes coming together in 2020…not that far away.Times of short-sighted focus by the market often presents compelling opportunities for investors willing to look a little further down the line. The current market fixation on near-term oil oversupply and pipeline takeaway constraints for parts of the US could make today one of those periods. In particularly, looking into 2020, we believe there are several additional factors that give us optimism. Those include
      1. Pipeline constraints being alleviated by new infrastructure (especially pipes leaving the Permian Basin) that will illicit greater completion activity to the benefit of oilfield service companies and current oil producers without firm transport on a pipeline;
      2. IMO 2020, which will require ships to burn low-sulfur fuel (with the effect of significantly tightening the diesel/distillate markets) or install scrubbers; and
      3. The continued absence of new large crude projects being added to the global market as a result of project cancellations during the prior downturn.

Considering the factors above and the market’s negative sentiment toward the sector, we think energy investors should stay the course and play for more than just a bounce off of oversold conditions. In our view, the current sector backdrop has presented an attractive buying opportunity for longer-term investors.



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