Energy/oil may have possibly broken out of a range in the low $70s (Brent Crude). There are a few factors coming together, with a change in the U.S. forecast (Energy Information Administration – EIA) – the latest bit of data supporting higher prices. Short-term trading markets, which have shown mild over-supply in their term structure for much of 2023, flipped into backwardation (tighter supply) in recent days. That suggests we may have seen a bottom in energy sentiments/stock prices. Things are seldom very clear in energy markets, with a great deal of opacity for both supply and demand, but a tight physical market is a tight physical market.
Post the Silicon Valley Bank failure, the market has reacted negatively to small seasonal inventory builds in global oil supplies and reasonably abundant oil on the short-term market, and priced energy equities for about $60-$65 LT crude. This is at the low end of the LT commodity price range suggested by the most credible and capital-disciplined producers. A tighter market, showing evidence that OPEC cuts are working, accompanied by fairly broad evidence that longer-term marginal costs are rising, is consistent with oil prices moving up either a bit or a lot, with upside/downside skewed favorably for the equities.
Global crude inventory (reported) was 1.23 bn barrels (bbls) in June, up from lows of 1.13 bn bbls in April 2022, so up 100 mm bbls in 14 months. The U.S. accounts for 457 mm bbls of this, and these figures exclude the United States’ Strategic Petroleum Reserve (SPR), which Biden & Co. have cut in half following the Russian invasion of Ukraine (if you count the SPR in the overall reserves, we are at major lows). An imbalance of 1 mm barrels per day (bpd) would, in theory, pull inventories back to 2022 lows over a few months, if not lower, triggering a change in global prices to urge supply and/or restrict demand.
Post 2020, we would argue that the cost of capital and expected capital returns to shareholders have gone up markedly. Investors understandably lost patience with “returns-free growth” in the 2010s.
OPEC puts out their own forecasts and had estimated a massive >2 mm bpd deficit for all of 2023, including 3-4 mm bpd deficits in the second half, which is not consistent with a $70 oil price (more like $100+). Markets clearly did not take deficit forecasts of this magnitude seriously. But all year long, the combo of China reopening, some still easy comps versus early 2022, and ongoing persistent consumption growth in non-OECD nations have buoyed a strong demand forecast with meaningful questions around the availability of supply, especially in the back half of the year, leading to big s/d deficits. But just how big, exactly? The International Energy Agency’s (IEA) most recent forecast in June called for year-end demand of 102.3 mm bpd, with supply of 101.3 excluding OPEC cuts, or a 1.0 mm bpd deficit in Q3-Q4 (so more like $90-ish). OPEC cuts make that deficit a good deal larger. Not to be confused with the EIA (Energy Information Administration, a U.S. government agency), which is now forecasting a 2H23 deficit of 0.7 mm bpd, which perhaps puts something in the $85-$90 range in play. A lot depends on the sustainability of OPEC cuts, announced in early April and with extra ones by the Saudis in June. OPEC was rather ineffectual during the years of big shale growth (2014-2019), but with shale growth slowing, OPEC is becoming more able to influence prices and market structure. If OPEC cuts just bring another million barrels from U.S. shale onto global markets (which they did in 2016-2018), then it’s pointless, but that scale of production growth in the USA is unlikely from here. Of the five major onshore oil formations in the U.S., only two are still growing (Permian and DJ Basin). Permian growth will overshadow declines from the decliners for a few more years, but it too is showing signs of maturity – which in oil-speak means growth potential becomes more limited.
The EIA’s most recent forecast pulled down U.S. forecasts of oil production from 12.61 mm bpd to 12.56 (not a lot) but, more interestingly brought down 2024e to 12.77, which is actually below their initial 2023 U.S. estimate from January of 12.8. That’s notable: just 2% overall production growth in ‘23-24, about 200k bpd. The shale boom is slowing. With FCF dominant in management remuneration, shale drilling efficiencies slowing, and meaningful questions about access to capital in a future crunch, rig counts have fallen decently this year. The private operators’ rigs are falling much harder than publicly traded ones, also an interesting sign. At a higher oil price than the $70s, I would assume some reversal of the declines in rigs and estimated production volumes, but the friction point in the $70s is evident. There are a lot of energy folks using $70-$75 as the “marginal barrel” price for shale barrels given the FCF/shareholder remuneration expectations. If marginal barrels really don’t happen <$70, that’s certainly a new twist versus the past 10+ years.
Back in April, OPEC announced they were planning on making cuts to production. What has been the impact so far? How do you foresee this playing out?
The OPEC cuts that were instituted in May, with additional ones in July, are now appearing to bite. Sour crude (that’s what Saudi exports) is now at a premium to sweet in the U.S. as our refinery complex is mainly set up to run sour grades, a legacy of pre-shale import dependency. These sour barrels are now in short supply. For much of the second quarter, oil markets were in contango (short-term price is below later dates), at least out a few months, creating an arbitrage opportunity to store barrels as opposed to using them. Contango is bearish – it means crude is well supplied and the market cannot fully digest all available supply, so the market prices time positively, encouraging storage. Backwardation (short term price is higher than long-term price) is actually more bullish, as it implies the opposite and will draw barrels out of storage. Last week the oil markets flipped to backwardation – a sign of tight near-term supply versus demand. Saudi exports to the U.S. will be close to zero for a few months – they are targeting the most visible and transparent commodity market in North America to push the market. Oil stocks have noticed. OPEC cuts have not always been so credible but when led by the Saudis and cohorts in the Gulf, which these are, compliance is usually strong. The Saudi’s are clearly trying to force the markets into inventory tightness and therefore take prices up.
The internal thesis I’ve been running with for energy investing is “The Era of Inconvenient Truths”. This past week featured the three reported hottest days globally in modern recorded history. The now-well-understood inconvenient truth of global warming has industrial offsets, which feature other inconvenient truths: far shorter planning horizons for major energy projects, capital discipline and hesitancy by producers, more restrictive access to producible reserves due to politics, and what may be unreasonable if not implausible expectations for the pace of a lower carbon transition in various kinds of transportation vehicles. Net, though EVs are up to almost a 10% share in the U.S. of new cars sold, the pace of gains is slowing, and on a global basis we are still adding traditional ICE vehicles to the overall fleet. Electric semi-trucks and other heavy machinery remain purely theoretical creatures. The electricity used to power EVs generally comes from coal or natural gas-powered electricity plants, which coupled with a high carbon footprint to obtain all the materials to make an EV, it’s not very clear what the real CO2 savings really are. The list goes on – the basic point for energy markets is that absent much capacity growth outside of OPEC nations, the cartel’s ability to influence prices is enhanced. While these supply reducers are in play, global demand growth remains a persistent reality, especially in highly populous emerging markets.
Can you discuss what the impacts of China’s demand and the Russian/Ukraine War will have on energy going forward?
In late 2022, oil traded in the $80-$100 range as the market eyeballed a (seemingly likely) loss of Russian crude from sanctions, an eventual reopening of China, a poor capacity to even meet production targets by many OPEC member states – offset by expectations of continued recovery/growth in North American (NAM) shale production, though not at anything like the growth rates of the 2010s. Net, given a demand forecast for >102 mm bpd in 2H23 (+2 mm bpd versus 2022) this collection of factors was expected to be a serious challenge to global oil supply, especially with very few larger scale projects coming on in 2023-2024.
The tight market supply/demand deficit in 2H23 has been brought into question by a few factors, the largest of which has been surprising supply. Russian supply did not decline sharply as expected, and they were cheating on their OPEC+ quota up until recently (quality data on this is nonexistent though). Iranian production is up a couple hundred thousand barrels per day, and even Venezuela is growing off a very low base. So yes, it’s all the world’s least charming countries growing exports, perhaps a different inconvenient truth to consider.
China’s post-COVID reopening has been underwhelming, with PMI data already turning south. Most of this is tied to Chinese construction, or a lack thereof, as the property bubble in China appears to finally be bursting. This has broad implications for a lot of commodities (such as iron and copper), and there is a lot of diesel consumed in construction, affecting demand growth forecasts (diesel in Denver, the home of Cambiar Investors, is below regular gasoline!). However, Chinese demand for oil as a transportation fuel is continuing to boom given a still very substantial penetration story for autos. Chinese purchases of oil were heavy/above demand for much of 2022, which I tend to think was due to exuberant CCP officials banking on a big reopening and expecting to need lots of oil for it. It has not quite been that, no, but the overall demand from China does continue to grow. Russian production has been the other complicating factor year to date, with expected declines of 500-1,000k bpd failing to materialize, as well as a big grey market tanker fleet materializing out of nowhere to take Russian oil to South Asia, where they kind of don’t care about the Ukraine war very much. So the invisible hand in this case, below-market priced $ barrels, has prevailed. There are a few production surprises rounding out the calculations – a bit more from Iran and Venezuela, but this is only a couple hundred thousand bpd – not enough to mark a big difference. The Russians are purportedly now complying with Saudi/OPEC production cuts, having probably received a stern talking-to at the Vienna meetings this spring.
How to forecast oil prices? – In 30+ years of doing this for a living, I’ve heard of at least 5-6 different theories to best explain oil prices. None of these work all that reliably – a great deal depends on prevailing marketplace narratives, which are inherently difficult to forecast.
- The marginal barrel theory – Oil will trend to the price of marginal barrel production (so $70-ish on the above comments, up from $50-ish in late 2010s).
- The “Saudi” rules – Rule #1 is to watch what the Saudis do. Rule #2 is to remember rule #1. Saudi crushed oil in 2020 to kill shale and force compliance, leading to the now infamous negative oil prices (briefly) in early 2020. But the Saudis also tightened the markets a lot in late 2020 and 2021 via hard cuts, which were successful. Saudi loosened the markets after the Russia-drive price surge in 2022. Now they are back to tightening. The Saudi rules have been working, lately.
- The spare capacity theory – Oil prices are driven by global spare capacity. As spare capacity gets thin (<2-3 mm bpd) prices will rise to constrain demand and reflect disruption risks (hurricanes, wars…). Global spare capacity goes up if OPEC withholds barrels, making OPEC cuts ineffectual. Certainly true in 2014-2019.
- The dollar theory – A strong dollar is bearish for oil and a weak dollar is bullish given overall commodity correlations to the dollar and longstanding U.S. oil import needs. This rule became obviously less relevant when U.S. oil production went from ~4 mm bpd to ~12+ mm bpd all due to shale, with nat gas also flipping into a significant exportable surplus. e., the dollar today is also a petrocurrency. Net, the dollar theory has become less relevant due to shale, but the correlations remain. The U.S. dollar is strong today versus history but has been weakening in 2023.
- The inventory theory – Tight physical inventories equal high prices, bulging inventory (with contango a point of evidence) equals weaker prices. This has been very true in 2020-2023. The current Saudi game plan targets inventory, especially in the U.S.
- Speculative positions – I don’t have an extensive history following speculative positions in energy commodities, but there is some evidence to suggest crowded longs (and shorts) usually mean we are going the other way. Net financial positioning as recently as the end of June was as bearish as in the summer of 2020 (which was like maximum bearish).
Given the complexities of energy, there is probably no one good theory that can be relied upon consistently. However, if we have a heavy alignment of theories, that probably leads to some weight in a particular direction. The Saudi rules theory is particularly relevant as leader of OPEC if the Era of Inconvenient Truths thesis is generally correct (gives them more power/effectiveness). As of mid-July, with global supply/demand expected to swing into deficit and draw inventories by almost all forecasts, OPEC intent on forcing markets into an outright tight physical situation, U.S. production flipping to negative growth this summer on lower rig counts, a weaker dollar, and bearish speculative positions, the opportunity for prices to swing the other way seems high. Nobody is very clear on what price range the Saudis want exactly. Is it $80-$90, $90-$100, or $100+? Rumors are that the Saudis need $85+ to balance their finances.
We are not in the business of making specific energy price forecasts but can at least comment on patterns and behaviors. This year’s behaviors include shale producers cutting rigs once the oil price fell into the low $70s, and we have also seen the Saudis spring into action with oil in the $70s. This suggests oil <$80 may be at least a bit below a sustainable equilibrium. For the moment, we are also rather surprised that the “global security” premium that was priced into oil last year has evaporated so completely. We have no clear idea how Russia’s war with Ukraine will evolve. But just speculating here – if Russia looks likely to lose the territory it currently occupies as part of an armistice, would it not make some sense to put energy supplies at risk to improve their bargaining position? Is it possible that the expected declines of Russian oil production from the loss of Western technologies are just taking a bit longer to be realized – kind of like long and variable lags to monetary policy? It just seems the market has become awfully complacent about these kinds of impacts.
How are you positioned within the Cambiar Large Cap Value portfolio and Opportunity Fund?
Given the disconnect between stocks in the first half of the year and our view on longer-term energy prices – and capital returns from those prices – we added several energy sector positions. After big outperformance last year, most energy stocks were down by double digit percentages in the first half of 2023. We added positions in Chevron, Cenovus (Canadian), and ConocoPhillips to our Large Cap portfolio and Cambiar Opportunity Fund.
What about in the Cambiar Aggressive Value ETF (CAMX), your more concentrated product offering?
We added Cenovus and Suncor (also Canadian) to the Aggressive Value ETF, which entered the year holding a position in Shell, and added an equipment and consumable provider NOV. We estimate that the embedded oil price in Chevron, ConocoPhillips, Cenovus, and Suncor lay in the mid to upper $50 range for most of the second quarter, creating upside potential if the commodity trades above this range sustainably. European major producers are uniquely cheap, with embedded oil prices closer to the high $40s. Cambiar also holds some midstream energy positions in Williams and Energy Transfer LP. These companies own major pipeline, storage, and handling infrastructure needed to move energy molecules from upstream production sites to downstream refineries and power facilities.
Can you provide some context behind these moves?
Hardly anyone has a good track record of forecasting energy commodity prices. They are inherently unstable. Post 2008, oil prices have leaned toward the marginal price over time, plus a (very small) premium for expected capital returns to shareholders. Natural gas in North America is a landlocked commodity that is not only easily produced by horizontal drilling and fracking but is often an unwanted by-product of oil-oriented shale wells. As a result, natural gas usually clears at a price below so-called marginal production costs, essentially to discourage production, though there are some really low–cost production basins for natural gas where the numbers still work in spite of this market structure. The poor capital discipline of the energy space in the 2010s, along with rapid improvements in shale technology/efficiency, meant oil and gas exhibited chronically “loose” supply, with gas really loose. Any sustained price increases tended to be met with rapid supply growth, leading to a series of price collapses. This meant that investors could not hold energy stocks easily through thick and thin, given the severity of the busts.
Post 2020, we would argue that the cost of capital and expected capital returns to shareholders have gone up markedly. Investors understandably lost patience with “returns-free growth” in the 2010s. Given a decrease in investors willing to participate at all in hydrocarbon energy – owing to long-term questions about the durability of demand, ESG-driven divestment, and other anti-carbon sentiments – those still willing to participate have come to expect material cash returns. There’s a longer conversation to be had here, but suffice to say that when the implied cost of capital rises in an economically necessary sector because it is, shall we say, unloved, participation is generally rewarded over time. Alternatively, when the cost of capital is near zero because investors just love it so much, participation can be pretty dangerous. The high expected shareholder remuneration decreases the potential to drill drill drill because a good chunk (typically 25%-40%) of energy companies’ operating cash flow is already allocated to shareholder returns. Management incentives at most energy companies have been changed to focus on financial returns over production growth.
The opposite applies to Canadian Oil Sands producers: they have almost zero annual production declines from their mines (their production is more about digging and hauling than drilling and pumping), and estimated reserve life is in decades. Production, cost, and reserve life… none of these are vague. Prior to the shale revolution, the Canadians traded at premium valuations owing to these characteristics. For now, they trade with significant FCF yields given the high cost of capital regime that pervades in the sector. If oil is, let’s say, resistant to declining below $80 on a sustained basis, and the production potential of shale becomes more visibly truncated, these names seem particularly disconnected from fair value currently.
Warren Buffett has an expression about commodities and commodity stocks: “they are hard, unless markets perceive there to be a durable supply challenge”. Is there a durable supply challenge? There is no case for the world to run out of oil anytime soon. There are plenty of geologically producible reserves in the Americas, Africa, Asia, and the Middle East. But are these politically and economically producible? That’s a more meaningful question and yet another inconvenient truth. They are not going to be politically easy, that part seems clear. An inconvenient truth demands a not-insignificant paycheck, is what it seems. For the Large Cap Value and Aggressive Value ETF, we have positioned ourselves with energy stocks that embed low or low-ish oil prices as a form of a margin of safety and driver of upside, especially given fairly high stock repurchases across the sector and in our names.
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