Dear Energy Investor,
Recently energy stocks have shown some strength. Energy outperformed the S&P500 for the first three-month-period since Third Quarter 2016.
Global growth is strong — estimated at 3.8% per year— and oil demand is increasing — estimated at 1.65 million BOPD on a base of 97.2 million BOPD. Global inventories returned to average levels — lower by 328 million barrels since 2017— resulting in higher prices — $70.70 at the writing of this newsletter compared to $45.49/barrel as of the writing of the 1Q17 newsletter one year ago. However, US inventories have increased since the beginning of the year, although they remain lower than they were in 2015, 2016 and 2017.
It may seem a bit of a contradiction: On the one hand, the OPEC and non-OPEC Declaration of Cooperationthat began in 2016 and was extended through 2018 appears to be working, although some argue that OPEC will overshoot and tighten the market too much. On the other hand, the US is adding more production than all other producers combined, which if supplies rise too much could trigger aprice correction amid financial volatility and overzealous positioning from hedge funds in the futures market.
Our hope for 2018 is that the Declaration of Cooperation will keep the two biggest producers outside of the US — Russia and Saudi Arabia — focused on “doing whatever it takes” (their words) to maintain prices. “The rebalancing of the oil market has likely been achieved, six months sooner than we had expected,” Goldman Sachs said in a recent note, predicting Brent will hit $82 per barrel before the end of the year.
It’s important to note that while world demand is growing investment in oil has declined. OPEC estimates that capital expenditure has seen a decline of around 42% compared to the 2014 level.The severe cutbacks in upstream spending that began when oil prices initially collapsed in 2014 have yet to really be felt in terms of supply. Large-scale projects that received funding before the market downturn were carried through to completion, allowing new supply to come onto the market even as the industry made sharp spending cutbacks. But that pipeline of projects is now dried up, which raises questions about the availability of supply next year and beyond.
The outlier in this investment story is US shale, which saw investment rise by more than 42% y-o-y in 2017, to about $138 billion.This helped US crude oil production exceed 10 million BOPD in November 2017. Now the EIA predicts US production will reach 11 million BOPD in 2018 and 12 million BOPD in 2019. In other words, the US has already surpassed Saudi Arabia, and will soon surpass Russia, to become the world’s largest oil producer.
Some of these figures and forecasts have been floating around for a while now, but the IEA put the situation in stark terms. The agency says that the current growth trajectory in shale production “is reminiscent of the first wave of US shale growth that, riding the tide of high oil prices in the early years of this decade, made big gains in terms of market share and eventually in 2014 forced a historic change of policy by leading producers.” At this rate supply growth from the US alone looks like it will equal total global demand growth.
So how have equities reacted to improving markets and higher prices? The short answer is not very well. For example, ExxonMobil stock (XOM) is down 4% year-to-date, while Chevron (CVX) is slightly positive. Why? Both majors had big earnings misses in January, which spooked investors and have yet to be forgiven. For the Fourth Quarter 2017 XOM earned $0.88 per share and CVX reported earnings of $0.72 per share, figures that were 15 percent and 40 percent lower than analysts’ expectations, respectively. First Quarter 2018 saw XOM miss again while CVX recovered. XOM earned $1.09 per share, which was 3 percent lower than analysts’ expectations, while CVX earned $1.90 per share, 28 percent higher than analysts’ expectations.
Even so, ExxonMobil recently announced plans to spend $50 billion on US shale over the next five years. By 2025, the oil major says it will quadruple its shale production to around 800,000 BOPD. Three quarters of the new production will come from the Permian Basin where the estimated ultimate recovery rose 20% from 3Q16 to 3Q17 and the average well cost per lateral length fell by 35% between 2014 and 2017. This contributed to a drop in the average breakeven price for US shale by as much as 40%.
Investment Themes
We overhauled the energy/natural resources investment strategy at the end of 2017. We decided to concentrate the portfolio in fewer, higher quality names, and to decrease exposure to US energy because of the ongoing potential for glut. At the same time we increased exposure to US infrastructure, which is badly in need of being rebuilt, and will benefit from the strong economy and relatively low energy prices. These changes have meant that the portfolio is currently positioned as follows:
· Exploration & Production – 25% (was 35%)
· Drilling & Oilfield Service – 18% (was 29%)
· Chemicals & Refining – 26% (was 16%)
· Infrastructure – 31% (was 0%)
· Special Situations – 0% (was 20%)
The last time we were this optimistic about energy was Second and Third Quarter of 2016. Names added then are up 5% cumulatively since. Energy stocks have not kept pace with the improvement in energy prices. This is a good time to add to portfolios because there is more to come.
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