There has been a significant improvement in crude fundamentals over the past few months. While demand weakened significantly in Q2 (we think skewed by destocking), notably in Europe, indicators point to a sharp inflection in July with the YOY run rate back to 1.3MM Bbl/d. At the same time, US inventory draws have accelerated and the YOY surplus has shrunk from 56MM Bbls in July to now 22MM Bbls and the “Big 3” category (oil + gasoline + distillate) has shrunk from a surplus of 49MM bbls to now only 12MM bbls:
While ongoing worries about the health of the global economy persist (due to Trump’s trade war with China) and oil is indeed exposed to daily tweeting volatility I believe the near-term direction of crude oil will be dictated by 2 fundamental factors: inventory declines and the US production growth rate.
With all but a handful of US E&P’s embracing buybacks + dividends over growth we have seen the US oil directed rig count fall by 131 rigs and with it a deceleration of the YOY growth rate of US production. This trend should accelerate in the coming months as company’s approach budget exhaustion:
It looks like the US production growth rate in 2020 is going to disappoint consensus expectations as E&P’s will continue to underspend cashflow and prioritize return of capital. To us it appears that US oil growth will be less than 1MM Bbl/d in 2020 which means that a further cut from OPEC will not be required. With this backdrop we are comfortable with a $55-$60 price band in our company cash flow forecasting and in that context oil stock valuations remain at their cheapest levels in history:
Given sound fundamentals yet deplorable sentiment we see several near-term catalysts that could shift sentiment in our favour, and with a 50%+ YTD performance gap between WTI versus many midcap stocks we see the potential for a meaningful Fall rally (coinciding with seasonal strength for crude oil):
Potential near-term catalysts:
1) Continued signs of US production growth deceleration
2) Lack of trade war rhetoric escalation and commensurate lessening of daily doomsday headlines which is killing sentiment
3) Canadian producers adopting meaningful share buyback programs in Q4/19 and 2020 given FCF yields of 20%+ and absolutely zero reward for growing their production
4) Pipeline progress: TMX shovels in the ground last Friday, KXL won their final significant court challenge, rail capacity is ramping by 150,000Bbl/d by YE, and pipeline throughput due to DRA and additional compression = 300,000Bbl/d of increased capacity (the WCS differential by the way is below $17/bbl for the next 13 months)
The oil market is much tighter today than a $56 price would suggest and with oil equities discounting ~$45/bbl we see highly meaningful upside when the shift in sentiment occurs. In the meantime companies continue to generate mountains of free cash flow with which to pay down debt and buy back shares that are trading at discounts to their liquidation value.
Senior Portfolio Manager
Ninepoint Energy Fund
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