- We believe supply-driven tightness in crude has been masked by investor macro concerns relating to demand, as well as the recent weather-impacted rise in US oil inventories.
- In our view, the magnitude of these supply factors more than offsets potential demand slippage and should result in a continuation of oil tightness.
- We see significant value in many oil-related equities, particularly those boosting free cash flow through enhanced operating efficiencies and capital spending discipline.
What’s wrong with oil? Lately, that’s a question we’ve been frequently asked, especially from those who have noticed the favorable, supply side-related geopolitical factors around the world including:
- Iran – Following the end of US waivers on the Iranian export ban, oil exports from that country have come to a near standstill, dropping below 900,000 barrels per day in April, from roughly 2.7 million barrels per day (mmbpd) a year ago. Moreover, this figure is widely expected to fall significantly lower, as US officials have confirmed that any new Iranian oil purchases from May 2 are subject to US sanctions.
- Venezuela – Crude output has fallen precipitously. Driven by US sanctions and overall political chaos, Venezuelan output now stands at just over 800k barrels per day, versus 2.4 mmbpd a few years ago and 1.2 mmbpd as recently as January.
- Russia – Recent reports indicate that oil production continued to fall in May after shipments via the Druzhba pipeline, which supplies 1.5 mmbpd of Urals crude, was found to be contaminated in April.
On a global oil market of roughly 100 mmbpd, supply drops of this magnitude are quite significant, particularly if they are more than just short-term events, as the case with both Iran and Venezuela seem to be. Granted, US oil production has been on a tear. The latest figures (February 2019) from US Energy Information Administration (EIA) has US production at 11.7 mmbpd, up a dramatic 1.4 mmbpd from a year ago and 2.7 mmbpd higher than just two years ago. Production capacity also appears set to rise in other non-OPEC countries like Brazil and China. Still, these issues pale in comparison to the aforementioned recent global supply shocks, not to mention the continued support OPEC has shown to oil prices with its stated intention to extend its policy of 1.6 mmbpd of production cuts that were initiated at the beginning of this year.
Oil’s tightness is most evidenced by the shape of the future’s curve, also called “time spreads.” For Brent (the leading global price benchmark for Atlantic basin crude oil), the backwardation in the curve has steepened dramatically in recent months. As shown in Exhibit 4, the spot price for Brent is significantly higher than the forward price. This signals a greater demand for barrels today and an environment that discourages hoarding inventories given lower future prices (or positive “roll yield”). Granted, for WTI crude, contango (the opposite of backwardation) exists in nearer months on the curve (largely influenced by rising US inventories to be discussed below). However, the WTI curve remains substantially backwardated in 2020 and beyond.
So what gives? How has the spot price for oil weakened in spite of these price supportive supply factors?
- Worries with Demand. Thus far, we have only discussed the “S” in the Supply-Demand dynamic for oil. Naturally, demand concerns have played a major factor. The consensus of EIA and OPEC agency forecasts is for global demand to grow 1.2 – 1.3 mmbpd in 2019, a rate rather consistent with recent years. Still, macro concerns relating to trade and slowing emerging markets (e.g., China’s latest PMI report) has dominated investor sentiment and has many focused on potential oil demand slippage. For instance, China’s National Development and Reform Commission reported a 2.4% year-over-year decline in oil products consumption in April, the first decline in three years. Also, Energy Aspects has preliminarily reported that global demand actually fell 0.3 mmbpd in March, following robust demand figures in January and February of this year. This would mark only the third monthly year over year decline since the bottom in oil prices in early 2016. Such a one-month drop does not make a trend. Still, it is undeniable that demand worries and related potential destocking by end-users are at the heart of the recent drop in spot crude prices.
- Rising inventories: Blame it on the Rain. Recent weeks have seen a large rise in US crude inventories as reported by the U.S. Department of Energy (DOE), rising at their fastest pace since 2016. Some of this rise was previously explained by normal spring refinery maintenance downtime. However, the latest counter-seasonal increase has many oil pundits worried that it implies a sharp fall-off in demand, à la similar tariff-driven concerns at the end of 2018.
While the weekly DOE figures have been undeniably bearish, it’s hard to discern how much relates to unexpected pipeline outages and refinery shutdowns recently due to flooding in the US Midwest. For example, pipelines and refineries that have been recently shut or curtailed include the 360k bpd Ozark Pipeline, Tallgrass Energy’s Iron Horse and Pony Express Pipelines, the 200k bpd Diamond pipeline, and HollyFrontier’s 155,300 bpd Tulsa, Oklahoma refinery. The impact of heavy rains is most evidenced in the inventory figures for flood-victimized PADD 2 (the Mid-Continent district), which has accounted for the vast majority of the inventory build over the past month.
- Currency headwind. Typically, a more dovish US monetary policy would be a catalyst for a weaker USD. However, just the opposite has occurred, as the continued rise in the USD reflects its status as a safehaven in times of heightened global uncertainty. As a result, the USD has recently become more correlated to relative global equity performance, rather than country interest rate differentials.
Oil, and most commodities, are priced in USD. Therefore, a higher USD raises the price for consumers abroad paying in local currencies. This demand dampening effect has historically played a large role in oil price cycles. As shown in Exhibit 6, the trade-weighted Brent crude price has substantially outperformed the regularly-quoted Brent spot price over the past five years given the USD’s dramatic strengthening over this period (approximately +25%). This outperformance was particularly evident last Fall when the Brent oil price peaked well below the peak of last cycle (mid-2014), yet the trade-weighted price nearly reached the prior cycle high, thus resulting in a greater threat of demand destruction abroad.
- The paper market. Our discussion of the oil’s tightness and supply/demand influences relates to the physical market for oil. However, the day-to-day price performance of the commodity is often largely a function of positioning in the paper market (financial market), which is estimated to be as much as 40x the size of the global physical market. Thus, changes in open interest levels (outstanding contracts) can have a significant impact on the spot price. This can result in exaggerated, or even contrarian, price movements to oil fundamentals.
Exhibit 7 shows the total open interest levels for NYMEX Crude Oil as reported each Tuesday by the Commodity Futures Trading Commission (CFTC), as well as the spot price for Brent crude. As illustrated, the recent price drop was accompanied by a sharp decline in open interest levels by oil traders. We note that changes in oil prices and open interest levels are not always consistent, such as in early 2017. However, open interest activity is often a predictor (or even a driver) of upcoming oil price movements, particularly at the high or low-end of the price range.
Often forgotten: The Spot Price Doesn’t Drive Value
We appreciate that short-term worries regarding demand and the recent rise in US inventories could continue to overshadow a tightening global picture for crude oil. Still, we stress that even if oil prices in the short term remain under pressure from macro factors, we believe the major valuation element to the equities of oil producers (and secondarily to oil service companies) is their future cash flows under longer term oil prices. In our view, there remains considerable value in select oil-related equities even assuming rather conservative long-term prices for crude. Such value is being particularly driven by increased production efficiencies and greater cash flow generation under new strategies of enhanced capital spending discipline.
The information provided does not constitute investment advice and is not an offering of or a solicitation to buy or sell any security, product, service or fund, including any fund that may be advertised.
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision.
Any charts, tables, and graphs contained in this document are not intended to be used to assist the reader in determining which securities to buy or sell or when to buy or sell securities. Any projections or other information in this blog post regarding the likelihood of various future outcomes are hypothetical in nature and do not guarantee any particular future results. Additional information is available upon request. Unless otherwise noted, the source of information for any charts, graphs, and other materials contained here is BPCFA. This document may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable; however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.