Author: Pieter Schop, Senior Portfolio Manager, Equity Specialties at NN Investment Partners
The oil price flat-lined for three months following last years’ OPEC announcement of a production ceiling. The expectation was that supply and demand would move towards an equilibrium with this agreement. But the market is losing faith. Doubts are triggered by the stubbornly high inventory levels of crude oil in the United States.
We knew the rebalancing act would take time. The elevated oil production levels by various member countries ahead of the production cuts is only now landing at the destination ports as it simply takes weeks to ship. As the US has the most idle storage capacity in the world, it receives a disproportional share of the glut. Once cleared, the rebalancing process is expected to start. On top of this, a strong macro-economic outlook across the world should bode well for oil demand and reduce levels of refined product stocks. But there are a number of counter forces. The fast response of the US tight oil sector undermines OPEC’s effectiveness.
US onshore production is forecast to replace about half of the intended supply cut by OPEC. As a result, the OPEC production freeze may not be sufficient to resolve the inventory glut and the market may need an extension of the cuts. Furthermore, most projects sanctioned in the boom times (2011-2014) are expected to deliver barrels soon.
As can be seen in the graph, sustainable price rallies in the commodity have started when inventory days dropped to below 57. Only our most bullish forecast brings us close to that level by the end of 2017 and even then it may be short lived as the trend is expected to revert in 2018. Risks to the upside may be demand outpacing relative low expectations in the current favorable macro outlook. There is hope beyond 2018 though, as we expect that the supply additions outside the US will tail off quickly which makes the longer term prospects look brighter. But this may be too far out.
We are conservatively positioned and prefer companies that have lowered their dependency on the level of the oil price. For example, Royal Dutch Shell and BP have done large cost savings to significantly reduce break-even levels. In addition, they have sold assets to reduce debt levels. Both actions support their enticing dividend, which is key to many investors. We also view the refining sector, which has a low correlation with the oil price, as attractive.
Favorable industry fundamentals and company actions allow refiners to reduce debt and grow the dividend. The ongoing investment in the midstream space diversifies exposure and promotes stability in returns. The sector will also profit most from the expected changes as a result of the Trump presidency with possible reductions in regulatory costs and corporate taxes. We believe in a defensive positioning, where we are likely to perform well if oil prices linger around current levels.