Returning to balance in supply and demand

The crude oil market is a clear reflection of supply and demand for a major world commodity. Changes in key factors can happen quickly or develop slowly over time, but they eventually are reflected in prices. We now believe the oil market is very close to a global supply/demand balance.

Supply/Demand Overview

We think a global oil oversupply of about 2% on a total of 95 million barrels per day (bpd) of global oil demand prompted the initial plunge in prices, but that compares with 9-10% in prior oil-price cycles. That means it won’t take much to get the world market back in balance. Global demand recently again has grown significantly in response to falling prices and economic growth. Most of that demand growth still is from emerging market countries. We estimate annual demand growth during the next five years will average 1 million bpd.

On the supply side, we believe U.S. output peaked at about 9.6 million bpd and will stabilize at about 8 million bpd. We think onshore U.S. producers offer the best opportunity for revenue growth, and these companies remain a focus for the Fund.

There are key influences on supply outside of the U.S., too. Political turmoil in Venezuela has affected the oil industry there and production has fallen nearly 400,000 bpd since the beginning of the year. We think Nigeria’s production may have fallen by 600,000 bpd. In addition, China’s production is down almost 15%, Mexico is down 10% and Russia has been flat this year. There also are ongoing problems for the oil industry in Libya. We estimate the decline in production overall at 1.5 million bpd.

Higher-than-expected demand and lower-than-expected supply helps confirm our view that the market overall will be in balance more quickly than many market participants now forecast.

We also think crude oil inventories will fall more quickly than many in the market now expect. Inventories are basically at a 30-year high. That's going to be some cushion as we start to balance the market and withdraw inventories, but new supply won’t come back online quickly. We think the cost curve for producing oil has shifted lower and has become more flat, so we now have more oil production available at a lower price. That’s true for production from the Organization of Petroleum Exporting Countries (OPEC) and from U.S. shale, where companies have continued to improve productivity and efficiency.

Direction of oil prices

We believe the oil market has bottomed. West Texas Intermediate crude oil — the U.S. price benchmark — reached a low of about $26 per barrel in February, which basically is the level of cash costs. In our view, that’s a price level that provided an incentive for supply to fall and we already have seen that decline, especially in the U.S. The price recovered to $50 in just over four months, a relevantly short period. We’re now watching for an indication of the price needed to prompt meaningful production growth in the U.S. again. It will be needed to satisfy the forecast demand of the next several years.

With oil at $50, we are starting to see evidence of an end to declines in the oil rig count – an important measure for the industry and markets. The rig count was down 80% in the U.S. during the past 18-24 months, and it will take significant time and spending to grow production again. The extended period of low prices caused companies to cut capital spending for two years in a row, effectively cancelling 5 million barrels worth of projects that had been planned for 2018-2020. This has happened before: the price falls, capital spending is cut, supply begins to decline and then demand increases on the back of cheaper oil plus economic growth. We believe it’s possible that an undersupply issue may develop in the coming years as companies struggle to ramp up production to meet growing demand.

One popular topic of the moment in the media relates to drilled but uncompleted wells, or “DUCs.” The view from some in the media and the investment community is that the number of DUCs available, primarily in the U.S., will mean a quick increase in supply is possible. Although DUCs certainly will be a part of the production increase equation, we do not believe the effect will be as meaningful as some reports contend. Many DUCs are located on the periphery of shale plays, meaning they produce relatively less crude oil and at a greater cost than higher-producing wells near the core of shale plays. Job layoffs in the sector also have been substantial, so companies do not have the staffing available to immediately begin new production.

We also think it’s important to note OPEC’s current approach. In November 2014, the organization made a key policy change in which it no longer would play the role of balancing the market. Instead, OPEC made it clear it would take market share and try to maximize production. It now appears that OPEC feels this goal has been accomplished, as it has indicated it does not plan to increase production further going forward.

Barring a surprise from OPEC or elsewhere, we think the price of oil will be in a range of $60-65 per barrel by year-end and probably reach $70-75 next year. We also think the oil market will be volatile in the future and more volatile than the past several years. OPEC has made it clear that it is unwilling to hold large-scale spare capacity. In our view, less spare capacity and a greater requirement for producers to moderate supply is likely to create more price volatility.

Portfolio review

When it comes to active versus passive indices, one differentiating factor is that many passive indices contain a high weighting in integrated oil companies, mainly Exxon Mobil Corp. and Chevron Corp.* We think it's important to know that in times of rising prices, the integrated oil companies historically have underperformed. We believe in active management and focus on companies that we think can grow in this “upcycle.” We want to have less investment now in integrated firms — unlike the indexes — and instead own the stocks of low-cost service companies and exploration & production (E&P) companies that we think are well positioned to benefit from higher prices and can grow.

Examples in the Fund include EOG Resources, Inc., Pioneer Natural Resources Co. and others that have good shale assets and are low-cost producers.* We think these firms have solid balance sheets and the ability to increase production. We think these high-quality companies will be among the first to start growing and that is why they are a focus in the Fund.

As we analyze master limited partnerships (MLPs) for the Fund, we think the biggest risk is that production still is declining and growth will be slow to restart. That means the industry is moving less product through the pipelines operated by MLPs. Pipeline capacity will be needed when substantial growth starts again, but we don’t believe we are at that point yet. In our view, E&P companies will show growth first, followed by oil services firms and later by MLPs.

In our view, alternative energy works when oil prices are high because then alternatives become more economical. Prices on alternative fuels also have tended to be volatile. The Fund now does not have much investment in alternatives. Alternative energy makes up about 1% of what the world consumes. We think that will quadruple in the next five to 10 years. By comparison, energy based on hydrocarbons makes up more than 80% of world consumption and we think that will continue. We do expect fewer nuclear power plants and less use of hydroelectric power because of environmental concerns.

* Pioneer Natural Resources Co.: 3.98%; EOG Resources, Inc.: 3.86%; Exxon Mobil Corp., 2.62%; Chevron Corp., 1.01% of net assets as of 06/30/2016.


Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 2016, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

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