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Oil is down 2% this morning on headlines that OPEC production could be increased in the 2H of 2018 (to be formalized at the next OPEC meeting on June 22nd). Is this surprising? Not entirely. The production cut put into place in 2016 has been extremely effective at eliminating the 300MM bbl oil glut as of March of this year (fastest decline in inventory levels in history) and as a result the price of oil (Brent) has rallied to a recent high of $80/bbl (still below Saudi Arabia’s $85/bbl fiscal break-even level). Is this the end of the oil rally?
Source: Ninepoint Partners
We have written extensively about why oil is in a multi-year bull market (http://www.ninepoint.com/commentary/commentaries/042018/energy-strategy-042018/ ). The basic tenants to this thesis are: 1) US production growth is constrained by pipeline capacity in the Permian in 2019 and spending restraint due to a prioritization of shareholder return of capital 2) continued strong demand growth 3) non-OPEC/US production that is about to go into a multi-year decline beginning in 2019 due to a lack of investment on long-lead projects during the oil bear market and 4) OPEC, post bringing on their shut-in production, lacks any spare capacity and has the inability to grow by more than ~ 0.1MM Bbl/d per year until 2023 due to a lack of spending on future projects (they were forced during the oil downturn to sacrifice oil industry investment in lieu of social spending lest they risk revolution).
Source: Simmons, May 21, 2018
We believe that OPEC (ie. Saudi) is worried about significantly over tightening the market this year due to the ongoing implosion in Venezuelan production and impending Iranian export restrictions. These amount to 0.7MM Bbl/d of losses from Venezuela and a 0.2-1.0MM Bbl/d impending reduction from Iran. Even without these two politically-induced production reductions we had estimated that OECD inventories would hit a 10 year low and that the market would be undersupplied by 1.1MM Bbl/d by the end of 2018. If the headlines prove to be accurate and OPEC brings on 0.3-0.8MM Bbl/d gradually to offset the Venezuelan/Iranian production loss the market will still remain undersupplied. Further, this will expedite the exhaustion of OPEC’s spare capacity which we believe to only be 0.6-1MM Bbl/d.
The narrative of ongoing inventory drawdowns is unchanged by OPEC increasing production this year (we had estimated that the full 1.2MM Bbl/d of supposed productive capacity would come online fully in 2019). Our call for $80/bbl oil in 2019 and the likelihood of $100/bbl oil in 2020 stands. OPEC/Russia will not do anything stupid to have the price of oil collapse after enduring the worst sell off in the history of oil over the past several years. Weakness in energy equities should (and we think will) be bought. From current levels we estimate 41% Fund upside using $70/bbl and 86% upside using $80/bbl (and these number will likely increase today). We remain in a multi-year bull market for oil.
1 All returns and fund details are a) based on Series F units; b) net of fees; c) annualized if period is greater than one year; d) as at April 30, 2018; e) 2004 annual returns are from 04/15/04 to 12/31/04. The index is 100% S&P/TSX Capped Energy TRI and is computed by Ninepoint Partners LP based on publicly available index information.† Since inception of fund Series F.
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