Memorial Day marks the unofficial start of summer, and Americans are projected to kick off the season by traveling in near-record numbers. According to AAA, more than 41.5 million Americans will travel this Memorial Day weekend, nearly 5 percent more than last year and the most in more than a dozen years. With nearly 2 million additional people traveling by planes, trains, and other modes of transportation, INRIX, a global transportation analytics company, expects that travel delays on major roads could be up to three times longer than normal, with the busiest days being Thursday and Friday (May 24-25) as commuters’ and holiday travelers’ plans coincide.
Daily National Average Gasoline Prices
With the national average gasoline price of $2.845 per gallon, and a healthy U.S. economy led by near 50-year low unemployment rates, we believe many Americans have all the motivation they need to kick off what we expect to be a busy summer travel season. We believe this will be one of many underlying factors that should support an increase in oil demand in the coming months.
With that said, the price of WTI crude oil has been pressured this week and is now priced at roughly $58 per barrel, approximately 12% below its April 23rd high of $66.30 per barrel. This week’s headlines read that this price decline is due to a surprise build in U.S. crude inventories, as well as fears that a full-blown trade war between the U.S. and China will weigh on demand.
However, if you peel back the layers to better understand what was behind the surprise build, we believe it was due in large part to two temporary factors:
- U.S. refineries had the lowest seasonal utilization rate (89.9%) since 2014. Normally at this time of year oil refineries are running closer to 91% to 92% of their capacity. Why is this important? When refineries are running at lower capacity, they don’t need to buy as much crude oil from the oil producers, and as a result, producers’ inventories build.
While some refineries were offline due to unplanned disruptions, others were offline completing maintenance and upgrades that are necessary to meet new environmental standards established by the International Maritime Organization (IMO) effective January 2020. We believe these issues will be short-lived and that refineries will materially increase their throughput (i.e. utilization) in the coming weeks. As a result, we would expect to see oil inventories decline in the second half of 2019.
- The closing of the Houston ship channel several times over the past few months also weighed heavily on oil inventory draws. These closures were due to a fire, a tanker collision, and significant weather related issues. Although the closures were temporary, they impacted both imports and exports, and they appear to have weighed more heavily on exports.
Beyond what we see as short-term influences on oil prices - non-fundamental issues and temporary circumstances - creating downward pressure on the price of oil and energy stocks these past couple of weeks, we continue to anticipate a more bullish case for this sector as the year progresses.
- OPEC is still intent on driving oil prices higher by driving inventories lower, especially in the U.S. Saudi Arabia’s budget requires $85 to $95 Brent oil. Without this price, Saudi Arabia continues to draw from their cash reserves. According to the Saudi Arabian Monetary Agency, during the last three years alone, they have reduced their reserves nearly 30%. Importantly, if Brent oil is only priced at $60 per barrel, the Kingdom would be on track to be out of reserves in five years - just to balance their budget! The Kingdom also needs to spend approximately $300 billion in maintenance and upgrades over the next decade just to MAINTAIN its 12 million barrel per day capacity. Current cash reserves are roughly $500 billion. Producing 10% to 12% of the world’s oil supply, a functioning Saudi Arabia is still important to the stability of oil prices.
Source: Saudi Arabian Monetary Agency, Tradingeconomics.com
- To this point, OPEC and its partners met this past weekend to discuss compliance with the group’s 1.2 million barrel per day production reduction agreement that has been in place since January 2019. OPEC will formally decide if it will keep the agreement in place beyond June at next month’s meeting. However, after the weekend’s compliance meeting, Saudi Energy Minister Khalid Al-Falih said that there was consensus among participants to continue to drive down crude inventories for the remainder of the year.
- We believe global oil demand is higher than the consensus indicates. The International Energy Agency (IEA) continues to make upward revisions to their previously understated estimated demand forecasts. As you can see on the chart below, while volatile from month-to-month or quarter-to-quarter, the trend for oil demand continues to rise.
Global Oil Products Demand
- Non-OPEC supply (mostly U.S. shale) is growing, but at a diminished pace and we believe U.S. shale, by itself, will be unable to cure the global oil imbalance. This will likely require an increase in offshore drilling. To this point, after listening to the first quarter earnings calls and having spoken with companies like Schlumberger, Halliburton, Ensco Rowan and Transocean, all are reporting an increase in specific planning, final investment decisions and new contracts.
- Geopolitical supply risks have increased due to rising global tensions in the Middle East which recently experienced attacks on oil tankers in the Strait of Hormuz and on a Saudi Arabian oil pipeline. Should a major pipeline be disrupted, this could cause a spike in the price of oil. We do not believe this risk has been priced in.
- There are significant supply concerns due to the United States taking a tough line on sanctions against Iran and the unrest in Venezuela and Libya leading to disruptions of oil supplies from those countries. As it relates to Venezuela, due to the way they have managed their energy industry and taken wells offline amid their economic and political turmoil, they have caused permanent damage to many of their wells and infrastructure. Therefore, even when they eventually find political stability, which is anyone’s guess at this point, we don’t expect their production levels to rise immediately.
Venezuela Oil Production
- It is important to remember that gasoline consumption increases seasonally. Typically, the first quarter of the year is the weakest and the fourth quarter is the strongest. So going forward, refinery throughput (i.e. utilization) increases are only a matter of time as refiners should draw down oil inventories to produce needed gasoline.
- When looking at oil demand relative to GDP growth, Cornerstone Analytics reports that for every 0.50% decline in GDP, there is roughly a 250 million barrel decline in oil demand. It is for this reason that, when looking back at recessions over the past 30 years, the demand for oil actually INCREASED during recessions, with the exception of 2008, and that decline in demand was relatively short-lived.
- We are now facing the tightest global oil market balance in decades (i.e. very little spare capacity), and we believe it's about to get even tighter in the 2nd half of 2019 as refinery throughput (i.e. higher utilization rates) ramps up ahead of the new emission standards that have been set by the International Maritime Organization slated for January 2020.
- According to Rystad Energy, global oil reserves are only being replaced at the rate of 7% per year. This reduced level hasn’t been seen since the 1940’s. In other words, by identifying new reserves and replacing just 7% of the oil that has already been extracted, we expect the draw down on current supplies to intensify, supporting the case for higher oil prices, which in turn will likely encourage more production and higher stock prices.
Based on book value, U.S. energy sector stocks are the lowest they have been in decades. We believe this sector is too cheap to ignore. Over the last 30 years the S&P 500 Energy Sector Index has traded at an average 0.8 times book value. Today, it is 37% cheaper at 0.5 times book value. If the S&P 500 Index were to remain flat, and the S&P 500 Energy Sector Index were to increase to its 30-year average, it would appreciate 60%. If it went to 1x book value it would appreciate 100%, and if it reached the previous peak of 1.3x book, it would appreciate 160%. So from a reward-to-risk perspective, we continue to strongly believe the energy sector represents tremendous value.
While we all may be frustrated by the recent lackluster moves in energy stocks, the fundamentals continue to support the case of higher oil prices and higher energy stock prices. We believe that investors need to keep in mind that the global supply shortage we are seeing in the physical oil market will be worsening into year-end and into the years ahead. This in turn should lead to materially higher prices. This is at the heart of our energy thesis and is why we continue to hold our energy positions.
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