Energy

Fundamental Shifts

Oil prices shrugged off OPEC's bullish announcement last week as the Organization of the Petroleum Exporting Countries (OPEC) agreed to extend its production cuts for nine months (through March 2018) at its semiannual meeting. The agreement was generally expected given prior meetings and comments from various countries involved. The cuts, representing about 2% of global supply, come mostly from Saudi Arabia and its Arab member nations, as well as a few nonmember nations, most notably Russia. The extension had been broadly communicated in recent days and oil was down after the news broke as some market participants likely expected a bigger cut or a longer extension into mid-2018. Much of the weakness in energy prices has been due to the surprising (to some) rebound in American production even in light of $45 $55 oil. This production growth is coming from both shale oil and increasingly offshore oil.

Improvements in offshore oil production technology are driving the cost of deepwater
oil production in a similar fashion to the way fracking and horizontal drilling drove down the cost of shale oil production. According to Wood Mackenzie Ltd, pumping crude from sea beds thousands of feet below water is turning cheaper because producers are implementing cost improvements and streamlining operations in core wells. That means oil at $50 a barrel could
sustain some of these projects by next year, down from an average breakeven price of about $62 in the first quarter of 2017 and $75 in 2014, the energy consultancy estimates.

The falling production costs make it more likely that investors will approve pumping crude from such large deepwater projects, the process for which is more complex and risky than drilling traditional fields on land. That may compete with OPEC’s oil to meet future supply gaps that the group sees forming as demand increases and output from existing wells naturally declines. Over the next three years, eight offshore projects may be approved with breakeven prices below $50, according to a Transocean Ltd. presentation at the Scotia Howard Weil Energy Conference in New Orleans in March. Eni SpA could reach a final investment decision on a $10 billion Nigeria deepwater project by October.

While costs for shale production, known as tight oil, are edging higher now, expenses associated with deepwater drilling are finally coming down. Rental rates for drilling rigs have been cut in half since 2014, and companies are redesigning projects to be more cost efficient instead of to maximize output.

According to Fitch Group’s BMI Research, deepwater exploration will see “renewed momentum” over the rest of 2017 as large integrated oil companies look to capitalize on lower service costs and strengthening fiscal positions. In the U.S. Gulf of Mexico, a more costefficient
design for deepwater projects has reduced the breakeven cost at many wells to below $40 a barrel.

(Additional investment specific comments follow for client subscribers)

Sources:

https://www.bloomberg.com/news/articles/20170530/
troublebrewingforopecasoncecostlydeepseaoilturnscheap

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Natural Resources

Summary:
•    Natural resources can add portfolio diversification and stability
•    Natural resource stocks are a good option and…
•    appear historically under-weighted and undervalued


The Case for Natural Resources Equity Investments
Natural resources are things like corn, cattle, wheat, coffee, iron ore, copper, natural gas, timber, oil, silver, and gold. They are sometimes consumed directly, as food and gasoline are, and they are also important inputs to the economic processes that create goods and deliver services. As input prices rise, the economic profit usually decreases in an economy. To use a very simple example, if a bakery must pay more for wheat flour and is unable to raise prices by a corresponding amount, the bakery’s profit will decline. Therefore, it follows that resource prices can often move inversely to the general economic ebb and flow. 

Unlike financial assets like stocks and bonds that derive their value through a combination of expected cash-flows and the interest rate at which those cash flows are priced, natural resources are valuable in and of themselves. While often volatile, with significant gains and losses in the short term, this inherent value leads to price stability and reduced risk over longer periods of time. 

By investing in companies that produce, harvest, manage, or conserve natural resources we can gain stock market returns (the equity risk premium) while also obtaining the diversification benefits of the natural resources themselves. The following charts from GMO show the long-term diversification benefits of including resource equity investments in an investment portfolio (Note: These charts specifically refer to energy and metals stocks due to the availability of long term historical data for these specific types of resource equities. Public investment options in agriculture equities have only recently become more widely available, but similar conclusions apply):

Despite these noteworthy portfolio benefits, investors generally do not have significant natural resource equity exposure. In recent years as commodity prices retreated, both the US S&P 500 and the global MSCI ACWI stock market index exposure to energy & metals dropped by more than 50%: 

However, current valuations of natural resource stocks are near 90 year lows when compared to their general stock market brethren:

In summary, natural resources can provide excellent diversification for investment portfolios and currently appear under-weighted and undervalued by many investors. By including these types of investments as specific asset classes and increasing our allocation to them, we may improve our long-term portfolio stability and return.


Reference:
White, Lucas. Grantham Mayo Van Otterloo & Co. LLC. An Investment Only a Mother Could Love: The Case for Natural Resource Equities. 2016. www.gmo.com

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

The Oil Market Is Back In Balance

The U.S. Energy Information Administration (EIA) recently reported domestic crude oil production declined by another 200,000 barrels per day over the most recent six week reporting period. The same EIA report also showed stocks of crude, gasoline, and distillates all falling during the period. In the simplest possible terms, these developments on the supply side mean that supply and demand are finally starting to come back into balance. 

For years OPEC represented essentially the lone source of incremental oil supply.  In fact, an often-used analogy was Saudi Aramco turning on and off the oil spigot to match oil demand. On the other hand, oil demand is fairly inelastic in the short run. Because of these dynamics, OPEC could achieve a large positive price response in exchange for a small reduction in supply.  In the last decade these monopolistic market tendencies evaporated as a new oil market reality emerged with American shale producers creating a market with multiple marginal suppliers. Today OPEC could make a large production cut, only to see American producers increase supply (and profits) at their expense. This is the dynamic OPEC leadership is referring to when you read of their unwillingness to cut supply due to their focus on “defending market share”.

The US oil supply growth of recent years was primarily driven by additional production from tight shale using horizontal drilling, fracking, injections, and other non-traditional methods. These new technologies unlocked access to large reserves that were known to exist, but were formerly thought to be uneconomical. Shale oil supply differs from traditional oil supply in two important areas. The first is that to drill and produce oil from a shale well costs more and therefore requires a much higher price of oil. Recent studies have put this breakeven price point somewhere around $50-$70 per barrel for a typical shale well, versus $20-$35 for a traditional well (this is an over-simplification for example purposes, actual well break-even levels can vary widely from well to well based on a variety of factors). The second difference is the expected production curve of the well. Traditional wells can produce for decades with little production decline, whereas typical shale oil wells expect substantial production declines within 18-24 months. In other words, shale production can be expected to begin declining less than two years after a sustained and substantial decline in drilling rig activity.

Much energy market analysis has focused on the role of OPEC in energy supply and on the recent reported failures of OPEC to agree to curb supply. However non-OPEC supply reductions (i.e. US shale producers) have continued right on schedule. Shortly after oil prices (thin gray line in the chart above) began their sharp drop in the second half of 2014, drilling activity as measured by the Baker-Hughes rig count (the bright red line in the chart above) declined precipitously by nearly 80% from the 2014 highs.

Given the relationship between drilling and production on a well-by-well basis, we might also expect the relationship to hold between drilling activity and shale production volumes in the aggregate. As shown in the chart below courtesy of Ned Davis Research via SPDR, not only does the relationship clearly hold, but the timing is spot on with what might have been our a priori expectation. 

Returning now to the global oil market picture, and remembering ECON 101, as price declines, we expect to see demand increase. Demand growth has occurred as the price of oil has declined. Much of the demand increase has come from the still rapidly growing emerging market economies. The IEA now expects India to begin overtaking China as the main engine of global demand growth, but expects both countries thirst for oil to remain strong. Therefore, we now have reduced supply combining with increased demand and this has now resulted in market flipping from an oil surplus to an oil deficit. The following chart from Goldman Sachs via Bloomberg illustrates the historical and projected market surplus/deficit (using Goldman’s current forward-looking estimates):

We believe that it is reasonable to assume that the oil price lows were reached in the first quarter of 2016. While prices may certainly decline from current levels between $45 and $50 per barrel, the global supply and demand picture demonstrates that a much lower price level would be unsustainable. 

However, while the physical oil markets are now re-balancing, the structural imbalance in the energy capital markets may be yet to reach such a point. While beyond the scope of this memo, it should be clear that drawing the conclusions we have about the state of the oil market is entirely different than drawing conclusions about the profit potential available to an equity investor in an oil producer. Many energy companies still must cope with large debt loads, much of which was incurred at substantially higher energy prices. While the new oil fundamental picture will continue to be constructive for many areas of the energy markets, capital restructuring adjustments may continue for some time.


SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.