On Thurs, May 25th, OPEC and several key non-OPEC oil producers agreed to extend the 1.8 million barrels per day production (mbd) cut that the group announced in November 2016. The nine-month extension was slightly longer than the original six-month deal in order to carry through the seasonally weak first quarter of 2018. Unlike the landmark announcement in November (the first to include non-OPEC members), the extension had been foreshadowed in recent remarks by key players Saudi Arabia and Russia. Thus, it came as little surprise to the market, as evidenced by the “sell-the-news” response in both oil and oil equities. It was also apparent that some pundits had hoped the cuts would be increased as well as expanded to Libya and Nigeria, rather than just maintained. Still, while less eventful than the previous two OPEC announcements, we believe the extension will prove significant in influencing the direction of oil prices and energy investing in upcoming months. In particular, we would highlight the following takeaways:
- Don’t underestimate Saudi Arabia’s determination to support/strengthen oil prices.
OPEC’s November 2014 decision not to curtail oil production, sending crude prices plummeting, now seems like an outlier. In sharp contrast, Saudi Arabia (easily OPEC’s largest producer and loudest voice) has since displayed an unwavering resolve to bring global inventory levels back to the five-year average, tightening oil markets. Such determination is hardly surprising, given the Kingdom’s heavy reliance on oil revenues (over 90% of budget sources), high unemployment rate, rising cost of social programs, and, maybe most importantly, the anticipated second half 2018 initial public offering (IPO) of state-owned Saudi Aramco. Regarding the latter, Saudi’s motivation for higher crude prices has been intensified by recent skepticism over the proposed value of the Initial Public Offering (IPO) and the ability to separate Saudi Aramco’s oil business from its involvement in other government activities. Moreover, it’s not been lost on the royal family that continued support of oil markets is likely needed in the face of rising US shale production. Saudi also undoubtedly understands the need for production cuts to serve as a bridge until the 2019/2020 period when supplies should be significantly hampered by previously canceled major projects around the globe. Finally, in what some have called an act of desperation, yet seen by others as a new-found strength, Saudi Arabia has partnered with oil giant Russia in promoting the cuts, overlooking their opposing sides regarding Syria and their historic animosity. In the press conference following the extension announcement, energy ministers from both countries, especially Saudi, were adamant that their exports in the second half of 2017 would be significantly reduced to the United States, the market where inventories have taken the longest to draw. And, while no formal exit strategy to the current OPEC policy has been discussed, it seems unlikely that cuts would be scrapped next March if the inventory target was not achieved.
- No Fly Zone removed. Now a focus on the data.
Many investors viewed the May 25 announcement with trepidation. Undoubtedly, the unexpected November 2014 announcement is still fresh in the memories of energy investors. And, despite strong premeeting indications of an extension, the possibility of another black swan event was not entirely dismissed in the market. As such, with the event now past, we believe the group has transitioned from No Fly Zone status for generalist investors to one that is now data dependent. Fortunately for energy stocks, that data has recently become more supportive of OPEC’s agenda taking effect, with the US Energy Information Administration (EIA) reporting consistent draws in US crude inventories in April and May of 2017. Still, to achieve OPEC’s goal of reducing supplies to the five-year average by year-end (an estimated 350 million barrel reduction globally), reports will need to show increased inventory draws in the second half of 2017. In favor of higher draws are reduced levels of Middle East inventories (especially floating storage), which were reduced atypically during the latest spring US refinery turnaround season. Also, global crude demand has remained solid and tends to accelerate in the second half of the year. Given the recent very lackluster performance by energy stocks, the group appears to be positioned to perform well given further positive inventory data points. Even with the latest reports on US inventory draws and the indications of an OPEC extension, most energy stocks have remained depressed and did not participate in oil’s pre-OPEC meeting price bounce. Thus, we were somewhat surprised when oil stocks sold off in tandem with oil on the OPEC announcement day. This decoupling of energy stocks with oil can been seen in the chart below, illustrating the Energy Select Sector Total Return Index (IXETR) versus the West Texas Intermediate (WTI) crude price.
- Bearish points on supply still likely to be a governor on oil price appreciation.
While we are encouraged by the extension and comments coming from the OPEC meeting, it is important to be cognizant of the more cautious points on supply that should continue to serve as some constraint on near-term oil price appreciation. On the day of the OPEC announcement, we were attending a sellside energy conference in Austin, Texas, where US Exploration and Production (E&P) companies highlighted their continued progress in driving down costs and growing production via longer horizontal laterals, multiple pay zones, and overall better fracking methods. Comments suggesting further rapid growth (especially from one large shale producer whose plan is to “drill through the cycles”) run distinctly counter to the intended effects of the OPEC production cuts now being extended. It is worth noting that slowing the proliferation of US shale was likely a key reason behind OPEC’s decision not to cut production in November 2014, and that US shale growth remains largely an unknown variable for OPEC. This has led some to wonder if the OPEC cuts are simply postponing the inevitable of shale production oversupplying the world.Admittedly, such supply concerns will likely persist as US shale continues to grow and given further increases in the reported US onshore oil rig count. Still, we believe there are several bullish points that often get overlooked. In particular, we note that the vast majority of the US production growth is coming from a handful of counties in one area of West Texas/Southern New Mexico called the Permian Basin. Already, issues such as labor availability and infrastructure (e.g., trucks, roads, water) are serving as real constraints to production and will likely increase in significance. Also, on a global basis, the potential for unplanned downtime at major projects and the dearth of new large projects on the horizon seem underappreciated. Finally, investor focus on issues still small in scope such as alternative energy and electric vehicles appears to neglect the likelihood of increasing oil demand over the next decade, for which shale production will be needed to supply.
At BP Capital Fund Advisors, we have positioned our funds with energy companies that we believe appear poised to benefit significantly from a bounce in oil prices stemming from lower global inventories, but also that may succeed in an environment of range-bound crude prices. We will continue to closely monitor the effects of the OPEC extension and global energy data points. Most importantly, we will continue to manage risk levels and portfolio volatility by investing in companies throughout the energy value chain.
- Don’t underestimate Saudi Arabia’s determination to support/strengthen oil prices.
The views in this material are intended to assist readers in understanding certain investment methodology and do not constitute investment or tax advice. Please consult your tax advisor. The views in this material were those of the author as of the date of publication and may not reflect their view on the date this material is first published or any time thereafter.
Descriptions and Definitions
Black Swan – An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict.
S&P 500 Index – The S&P 500 is a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
West Texas Intermediate (“WTI”) is a grade of crude oil used as a benchmark in oil pricing.
One cannot invest directly in an index.
Investors should consider the investment objective, risks, charges, and expenses of the BP Capital TwinLine Funds carefully before investing. A prospectus with this and other information about the Funds may be obtained by calling 1-855-40-BPCAP (1-855-402-7227). Please read the prospectus carefully before investing.
As with any mutual fund, it is possible to lose money by investing in the BP Capital TwinLine® Funds. An investment in either Fund is subject to other risks that are more fully described in the prospectus, including but not limited to risks in Master Limited Partnerships (“MLPs”) include, cash flow, fund structure risk and MLP tax risk plus regulatory risks. The prices of MLP units may fluctuate abruptly and trading volume may be low, making it difficult for the Funds to sell its units at a favorable price.
An investment in the BP Capital TwinLine® MLP Fund is, also, subject to risks, include but are not limited to non-diversification, energy-related sector, small-cap and mid-cap stocks, initial public offerings, high-yield “junk” bonds, and derivatives. The Fund is treated as a regular corporation, or “C” corporation, for U.S. federal income tax purposes. Accordingly, unlike traditional open-end mutual funds, the Fund is subject to U.S. federal income tax on its taxable income at the graduated rates applicable to corporations (currently a maximum rate of 35%) as well as state and local income taxes. The Fund will not benefit from current favorable federal income tax rates on long-term capital gains, and Fund income and losses will not be passed on to shareholders. The BP Capital TwinLine® MLP Fund may, also, invest in MLPs that are taxed as “C” corporations.
An investment in the BP Capital TwinLine® Energy Fund is, also, subject to risks, include but are not limited to non-diversified, energy-related sector, small-cap and mid-cap stocks, initial public offerings, high-yield “junk” bonds. The Fund expects that a significant portion of its distributions to shareholders will be characterized as a “return of capital” because of its MLP investments. If the Fund’s MLP investments exceed 25% of its assets, the Fund may not qualify for treatment as a regulated investment company (“RIC”) under the Internal Revenue Code (“Code”). The Fund would be taxed as an ordinary corporation, which could substantially reduce the Fund’s net assets and its distributions to shareholders.
Shares of the Funds are distributed by Foreside Fund Services, LLC, not affiliated with BP Capital.