Despite oil falling back below $50 for the first time in many months earlier in May, we remain convinced conditions still support an oil price of between $60-65 by the end of the year.
While fear and scepticism continues to feature heavily within the market, we believe this is an interesting time to invest in energy.
Performance of Brent crude over 3yrs
Source: FE Analytics
After years of shrinking cash flows – with the resulting decimation of capex on long-cycle oil supply projects that take four to eight years to start production – the market is finally clearing its excess oil inventories.
The impact of OPEC’s decision to switch its emphasis from targeting price to targeting inventory levels should not be underestimated.
Although the market assumed that the aim of Saudi Arabia, the dominant member of OPEC, was to drive out US shale production, the lower oil prices its oversupply created has resulted in the strangling of the 30m of barrels produced offshore. These are the projects that need four to seven years of investment to come on-stream.
While US shale in the Permian Basin may continue its strong growth trajectory, its 2 per cent contribution to global oil production pales against the 30 million barrels produced offshore per day. This tactic will result in a strong supply correction that will create enough room for OPEC to return to the market in 2018.
Recent efforts to target inventories mean we are now entering a period when, as we progress towards 2021, activity has to be extremely strong in order to balance what increasingly seems like an undersupplied market.
As we move towards a balancing of inventories, investor focus will switch from dividends and move towards looking at capex and reserve replacement ratios. Therefore, investors seeking to capitalise on the value on offer in the energy sector should gravitate towards high oil price sensitivity areas of the market to maximise the rewards during this strong phase of the cycle.
The lack of spending always comes home to roost
Despite being optimistic on the price, we are currently underweight in the oil majors. While we are positive on these companies, we simply see more compelling ideas elsewhere. The majors will soon realise the need to start addressing production issues.
Without enough long-cycle projects available, more mergers and acquisitions in short-cycle exploration and production companies (E&Ps) will be required, as well as the move to offshore projects – an area of the market that has been decimated in recent years.
Oil companies found less oil in 2015 than was found in 1947. It was even worse in 2016, with sanctioned projects hitting the lowest level since the Second World War.
If our thesis of $60-65 oil by year-end is correct, it is still reasonable to be looking onshore, but there will be a move from the Permian Basin towards the Eagle Ford and Bakken fields.
If E&Ps could make $30 oil work in the Permian, these operators are enjoying an additional $20 of earnings on today’s $50 oil price. If oil prices move to $65, this is almost a further doubling of earnings. However, if operators in Eagle Ford or Bakken are making $1 on a $50 oil price, it will be a multiple earnings impact should the price move to $65.
Following this, if the projects coming online in 2018 and 2019 appear lean and the market begins to become extremely tight, oil prices may jump to $80 by 2018-19, particularly if we see a return of a risk premium, something not encountered recently due to the comfort large storage volumes gave to the market.
Therefore, an allocation to the offshore market by the end of this year must be considered. In fact, we have dipped back into offshore, buying into operations that have addressed balance sheet concerns. These are names such as Borr Drilling and Songa Offshore.
We are extremely confident the oil space will be a good place for investors to be over the next three to five years. Historically, a poor period featuring a lack of spending, as we have witnessed over the past five to eight years, has been followed by an equally long period of outperformance. The lack of spending always comes home to roost. With inventories soon to balance, the psyche of the market should move and the questions posed by investors will also change. With the dynamics currently in place, we expect to witness significant opportunities as the oil price moves higher.
Richard Robinson is manager of the Ashburton Global Energy fund. The views expressed above are his own and should not be taken as investment advice.