Few things stir emotions amongst investors more than the price of oil. Most of us use oil in some form or another, and an increasing number of people do not want to use it at all.
Oil is also geopolitically sensitive and hugely important to most governments around the globe whether they be net producers or consumers. It is for this very reason that the majority of global oil production is still controlled by governments and not companies such as Shell or Exxon Mobil who are simply price takers in most respects.
The importance of oil to the global economy means that we are constantly monitoring the oil market as it can affect everything from consumer behaviour to inflation expectations and the cost of mortgages. Our macroeconomic (or top-down) approach to portfolio management means that we spend time analysing the oil market, the result of which has implications for many of our investment decisions across the asset classes.
This note offers some insight into our analysis of the oil market and how that led to a profitable investment in clients’ portfolios in early 2018. We hope this provides a useful case study of what we do.
We begin with a chart of the oil price, which neatly displays its volatility and unpredictability, in this case since 2007:
The Middle East (Saudi Arabia in particular) is still the key swing oil producer but North America is now the key marginal producer due to the huge expansion of the shale oil industry in recent years:
2017 Total Global Crude Oil Production (92.7 mbpd)
Source: Eni World Oil Review 2018
U.S. shale oil has accounted for no less than 80% of the rise in global crude oil supplies since 2010:
Increase in Global Crude Oil Supplies (mbbl)
Source: MacroStrategy Partnership LLP
However, it is not an unblemished story. The economics of U.S. shale oil production have been deteriorating for some time mainly because the production life of oil wells has been shorter than expected as the oil is released from the shale formations under extreme pressure. In 2017 we became concerned that there could be significant financing issues for these companies that are typically heavily dependent on debt to finance their operations. Our fears were eventually confirmed by the table below which showed that by Q3 2018 only one third of US shale companies were cash flow positive when WTI (the U.S. oil price) averaged $69.75:
Capital Expenditures vs. Cash Flow
US Shale Companies
Source: Yahoo Finance & Labyrinth Consulting Services
For how long will capital be made available to a loss-making industry? If lenders retreat from the oil sector then we may well see a marked fall in production, with huge implications for global oil supply.
The chart below shows just how quickly shale oil deposits are depleted:
Average Oil Production per Well in the Permian Region
We also had deep concerns about oil production in the developing world given the geopolitical problems in Venezuela and Iran which both hold significant proportions of global oil reserves and were subject to the threat of sanctions by the Trump administration:
World’s Crude Oil Reserves by Country (billion barrels)
We note another area of concern with respect to oil supply. Much of the world’s oil supply exists as poor quality “sour” crude under the ground and needs a lot of refining to remove the high sulphur content so that it can be transformed into oil products such as petrol and plastics. The International Maritime Organisation (“IMO”) announced that the wanted to lower the limit for bunker fuel sulphur content from 3.5% to 0.5% from January 2020. As we approach January 2020, demand for low-sulphur (sweet) crude oil will increase by as much as 2 million barrels per day which could have quite a dramatic impact on oil prices. We do not expect the Middle East to be the swing producer when “IMO 2020” begins to impact oil prices – there is no sweet oil there and not enough global refining capacity to convert sour grades to sweet to meet projected demand. This could create potential bottlenecks in supply with sweet crude benchmarks such as Brent and WTI rising significantly.
Adding insult to injury, the production capacity of the Ghawar oil field (the world’s biggest) in Saudi Arabia, has just been revised down by 2 million barrels per day.
The issues discussed above are directly reflected in the behaviour of the oil market in more recent years. Oil prices do not correlate with manufacturing activity (“PMIs”) at present but are instead driven by supply shocks and the reversals of those shocks:
Brent Oil Prices vs. Global Manufacturing PMI
3-Month Average, 2014-18
Sources: The Daily Shot (WSJ), FTN Financial
All of these supply problems caused us to raise our oil price expectation above market consensus. Much depends on demand as well but a number of oil producing nations depend on oil being above $70 to help balance the books so we expected the price to be well defended in the event of any demand shock (in 2017 the price was in the mid-$50 range). Russia, Saudi Arabia and the U.A.E. are the biggest winners of a rising oil prices with large oil-importing Emerging Market countries being the biggest losers:
Impact on 2020 GDP if Oil Prices Reach $100
Source: Oxford Economics
This chart was highly instructive for our analysis of the oil market and how best to express our “bullish” view on the oil price in clients’ portfolios in early 2018. Our investigations led us to the Russian equity market, not an area that we have been directly invested in before. The chart below shows the material exposure to the Energy sector within the Russian equity index:
The high exposure to the Energy sector suggested that the index would be a relatively efficient proxy for oil. Prevailing equity market valuations are also a key consideration for the timing of any investment and when we saw the Russian equity market was trading on 7.5x price/earnings (compared to a mean historic multiple of 20x) with a dividend yield of 5% we felt there was an opportunity to “buy” oil at a discount.
Further assurance was provided by our understanding of notable improvements in Russian corporate governance in recent years. Many companies now pay out a much higher proportion of their profits as dividends which we see as a key indicator of sound financial discipline. Sberbank, the largest non-Energy company within the index, has increased its dividend payout ratio from 8% to 50% over the last 10 years. Putin has also been keen for companies to pay out more of their profits to shareholders as it helps to prevent kleptocratic executives from pocketing all the winnings.
We are well aware of the risks of investing in Russia, but the macroeconomic and political environments are stable, certainly when compared to the U.S. and U.K. Inflation has been well contained by a highly competent central bank, despite a weak rouble which has suffered under Western sanctions. Ironically, the weakness of the rouble has magnified Russia’s oil revenues as oil trades in U.S. dollars so were not as concerned about the effects of sanctions as we are with Iran and Venezuela.
In summary, our initial interest in oil and our belief in 2017/2018 that the price of oil was going to be higher for longer led us to an investment in Russian equities.
The Russian equity position in clients’ portfolios has provided a material contribution to performance since we initiated the position in January 2018. However, with the oil price falling back to $60 in recent weeks and Russian equities continuing to climb we felt it would be prudent to lock in some profits so trimmed the position last week.
We maintain our “bullish” stance on oil and believe Russian equities will continue to “rerate”, certainly relative to other Emerging Markets, so are happy to let the remaining position run for the time being. However, we are mindful that alternative sources of energy are becoming more dominant and we expect fossil fuels to be phased out over the next 10 to 15 years so do not expect to remain “bullish” on oil over the long-term.
Quartet Investment Managers, July 2019