Ashburton: Oil price could overshoot on the upside
For the past two years oil prices have been on a veritable rollercoaster ride, what’s the outlook as we head into the mid-point of 2016?
Oil markets started 2015 still in the grips of OPEC’s about-face in November 2014, when the oil producers’ cartel decided to no longer act as the ‘swing producer’ (market balancer). Until end-2014, OPEC’s policy had been to protect an oil price which they regarded as ‘fair’ (over US$100 per barrel) but to also avoid prices that may jeopardise economic growth and, therefore, oil demand.
Essentially OPEC was striving for high prices but with low price volatility, something they had been successful in achieving; in fact 2013 oil price volatility was the lowest in a decade. However, the unintended consequence was to create fertile conditions for the United States to grow and develop its short-cycle unconventional oil shale. Worried about the growth in United States shale and OPEC’s declining market share (Saudi Arabia, the OPEC policy setter, saw market share drop from 11.7% in 1995 to 9.9% by late 2014), OPEC’s pricing policy changed. OPEC turned on the taps, putting most of its ‘spare capacity’ to work, with an objective of driving the price, and therefore non-OPEC production, lower. As a result, 2015 saw an oversupply of approximately 1.8 million barrels a day, as non-OPEC production took time to respond.
Oil prices plummeted, falling to a US$40 barrel low in August 2015, before sinking further to US$26/barrel in January 2016. The managers of the Ashburton Global Energy Fund, while maintaining a long- term view, are extremely cognisant of the cyclical nature of the sector. Consequently, the managers have adopted an investment process that looks to reduce the Fund’s sensitivity to the oil price at the negative end of the oil price cycle, while increasing it during the positive part of the cycle. Having spent most of last year with a negative outlook on the oil price the managers employed an oil price sensitivity that was 5%-10% lower than the benchmark.
The Fund performed well, outperforming its benchmark by 12% (ranking it, according to Morningstar, as the top energy fund, globally, over the last 12 months). Most of the outperformance during 2015 emanated from an overweight stance in the shipping sector (a sector with a low oil price sensitivity) which performed relatively well, thanks to increasing volumes of demand (an approximate rule of thumb is that every US$10 fall in the oil price should be reflected by a 0.1% increase in demand).
However, in November 2015, the managers became more bullish on the oil price outlook. A combination of data and face-to-face conversations with companies during road trips to Texas, United States, consolidated a view that we would see significant capital spend contractions in 2016, and therefore lower supply. Armed with a more bullish oil price outlook, we have continued to switch into higher oil price sensitive stocks. Since the end of January our overweight stance in the higher oil price sensitive areas has been rewarded, with exploration and production companies and services leading the alpha generation.
This approach is already bearing fruit with the Fund rising almost 36% and outperforming the benchmark, between January and mid-April, by almost 4%. In the past, supply driven markets have been notoriously slow to respond and have taken years or even decades to rebalance. This particular supply-driven correction is different because although a significant amount of oil can quickly enter the market, it will also rapidly deplete (well production falls 55%-75% in the first year. This oil is known as ‘short cycle’ oil and is being sourced from ‘unconventional’ United States resources (specifically fracked shale). Investments in short cycle oil production (it costs approximately US$6-US$7 million per well) are predicated on a well-by-well basis, unlike the behemoth long cycle oil projects (e.g. Prudhoe Bay in Alaska or Cantarell in Mexico), which are approved based on the full oil price cycle view.
Consequently, once approved and the billions of dollars of cost are sunk, long cycle oil’s production is divorced from oil price swings. We are already seeing the advantage of being supplied by this more pragmatic source of supply and are seeing strong evidence that supply is being reduced. The United States is seeing a 90% reduction in new oil already 600kbbld lower since June. We have also begun to see a fall in more mature sources of oil, such as China. China has just reduced 2016 production targets by 6.86% to four million barrels. Demand is, however, recovering from its recent (seasonal) softness and looks like outpacing the last decades average compound annual growth rate of 1.1% and settling between 1.3% and 1.5% higher for 2016 (the International Energy Agency believe that the world’s energy demand growth over the next decade will, in fact, outpace the demand growth of the last decade).
We are retaining high oil price sensitivity as a tightening market should lead to firmer oil prices. Indeed, International Energy Agency chief Fatih Birol has begun to warn that the combination of a sharp drop in non-OPEC supply and the largest back-to-back drops in upstream activity since the 1980s will lead to tightening markets and the creation increasingly met by United States onshore short cycle production. We would agree, but believe that although short cycle oil will be the first to recover, the scale of the recovery will ultimately be insufficient to compensate for the shortage in long cycle oil, since long cycle (offshore) oil produces approximately 30% of global supply and short cycle oil just 5%. Consequently, in order to incentivise the ‘base load’ of production from the more expensive but critical, long cycle oil, markets will need a price above US$65/ barrel in order to be adequately supplied over the longer term. The longer we remain below this level, the wider the supply shortage could become and the more likely we are to see an oil price overshoot on the upside. This could be the seed that starts to move the global oil price back towards triple digit oil levels as we approach 2020.
Richard Robinson, fund manager, Ashburton Investments Oil and the Global Energy Fund