A time to be selective in the energy sector
by Michael T. Wolverton, CFA Portfolio Manager
Crude oil prices are up about $15 to $20 per barrel from their 2016 lows and we believe exposure to specific elements of the energy sector is especially important now. However, we do not think broad exposure across the industry is desirable in the current environment.
Ongoing role of shale oil
The continued policy from the Organization of Petroleum Exporting Countries (OPEC) of reduced production has created a floor for oil prices around $50 per barrel. In our view, the only real risk to that general floor for a sustained period would be if OPEC reverses course and competes for market share instead of trying to maintain a price point. However, at this point we do not expect OPEC to make such a change.
OPEC in May 2017 decided to extend its agreed output reduction to March 2018. But demand for oil continues to grow around the world. We believe the U.S. will be the largest contributor to global supply growth in the next two to three years via the continued growth of shale oil production. We have positioned the Strategy based on this view.
Selecting among specific shale areas is important in identifying potential opportunities for the Strategy. We have a particular focus on the Permian Basin, where proven reserves are significant and we believe there is opportunity for continued production growth.
By contrast with our focus on companies involved in shale oil and related activities, passively managed energy funds — as well as many actively managed funds that more closely track an industry benchmark index — typically invest 30–50% of assets in the integrated oil companies, which have exposure globally to all facets of oil production.
Although we believe that a ramp up in offshore production will be needed to meet global demand in the next two years, we do not favor significant exposure to offshore now because the cost of production in most cases is higher than current oil prices.
Market overlooks key fundamentals
We think “headline risk” — or the market’s reaction to media reports – remains the greatest source of volatility for oil prices. Energy is perhaps the most politicized sector in the market and is the most subject to geopolitical risk. We believe the market is selectively pricing in fundamentals and is not taking all inputs into account.
For example, U.S. production is rising and companies are working to gain efficiency and lower breakeven costs. However, the sector still is squeezed financially and exploration and production (E&P) companies cannot enter a significant global expansion until oil prices reach a range of $65 to $80 per barrel.
If oil remains around $50, we think there will be significant shortfalls in supply within two years. The U.S. is the only area in the world that is growing production now and that growth will not compensate for growing global demand and declining rates from existing wells.
Although costs have declined significantly since the first advance in shale oil output, higher oil prices will be needed to spur a greater level of investment. We do not believe that U.S. shale oil alone can satisfy global demand by 2020, meaning there may be future opportunities for the Strategy in areas outside North America.
We also believe oil inventories are being misread or overlooked by the market. We believe inventories have turned a corner in the U.S.:
- Inventories peaked on March 31 and have declined slightly each week through April and May.1
- Oil inventories remain high relative to recent history. We believe the market is dismissing the recent decline rate as insignificant, relative to the total inventory number.
- We believe it is important to remember that April and May historically have been times when inventories tended to grow. Prior to the peak summer demand season — driven largely by gasoline and jet fuel use in the main travel period — inventories typically have risen then fallen during the summer months. We think demand will pick up in the summer, as is typical, and cause the inventory decline rate to increase.
The lower cost of production for shale oil producers is another example of what we consider a misleading narrative in many media reports. We believe production costs have fallen, and in fact focus the Strategy on companies that are low-cost leaders, are increasing efficiency or hold technology that gives them a meaningful competitive advantage. But it’s important to recognize that the energy industry as a whole was able to absorb some costs during a relatively short-term decline in oil prices in 2016–17. We believe the industry cannot accept such costs in the long term.
For example, oil services companies such as Halliburton Co. and Schlumberger Ltd. were willing to accept substantial cuts to their compensation from E&P companies when oil prices were at $30 to $45 barrel. As oil prices rise, the services companies will seek to profit in line with the E&P companies that hire them. Rising costs mean oil prices also must rise in order for all companies in the industry to thrive.
In general, we think the cost of drilling new shale wells will trend slightly higher in the coming years. Wells that have a breakeven price equivalent to $30 to $40 per barrel were drilled in the core of shale basins, where each well produces more oil. As those areas dry up, new wells will be on the periphery. Revenues automatically will fall because the costs will be similar but the output will be less.
In addition, oil-well technology continues to change and affect costs. We estimate a shale oil well that used hydraulic fracturing, or “fracking,” in 2014 needed about 4 million pounds of sand. The industry today knows that more sand causes fissures in the shale to open wider and stay open longer, allowing the recovery of more oil. We now estimate that fracking in 2017 uses 10-12 million pounds per well. Looked at another way, Pioneer Natural Resources Co.’s sand use has surged 70% since 2013 to 1,700 pounds per lateral foot of drilled well. The company says it will test wells this year using 3,000 pounds per foot. 2 Much of this sand is mined in Wisconsin and transported to various shale areas around the U.S. — an expensive process.
Taking a selective approach
We believe the energy sector presents significant potential opportunities with oil in its current price range. We estimate global oil demand is growing steadily this year at a pace of 1.2-1.4 million bpd, about 20–40% above its recent historical average. After two years of slowing supply growth, we believe we are in the beginning stages of supply reacceleration in certain areas of the world, with the U.S. showing the fastest move. We think the pace of supply growth in the U.S. could reach 1 million bpd by the end of 2017.
We believe an oil price of $55 to $65 per barrel would provide sufficient cash flow to allow continued supply growth from the U.S. for the next couple years and make it the largest contributor to growth for the near future. That leads us to believe U.S.-focused production companies are likely to have the highest growth rates and offer potential opportunities to reduce costs through productivity gains. Higher prices will be needed in the coming years in order to balance global supply and demand.
In our view, a prudent way to pursue these potential opportunities is via an actively managed approach that focuses on areas of the market that may be poised to grow — not through broad energy exposure — and that is the approach we are taking with the Strategy.
1 Source: U.S. Energy Information Administration, Weekly U.S. Ending Stocks excluding Strategic Petroleum Reserve of Crude Oil, May 2017
2 Source: “Latest Threat to U.S. Oil Drillers: The Rocketing Price of Sand,” The Wall Street Journal, May 26, 2017
- We think U.S. will be the largest contributor to supply growth in the next 2-3 years.
- We have a particular investment focus on the Permian Basin.
- We think "headline risk" remains greatest source of price volatility.
David P. Ginther, CPA
Senior Vice President, Portfolio Manager
Mr. Ginther is co-portfolio manager of the firm’s Energy investment strategy and has served in this role since 2006. He assumed portfolio manager responsibilities for the firm’s Natural Resources funds in 2013. He held portfolio management responsibilities for the firm’s Dividend Opportunities mutual funds from 2003 to 2013. He joined the firm as an equity investment analyst in 1995 and covered industries in the Energy, Materials and Utilities sectors.
Mr. Ginther had previously been a senior business analyst with Amoco Corporation. He began his career with Amoco in 1986. He experienced a variety of opportunities while at Amoco related to exploration and international financial reporting.
Mr. Ginther earned a BS in Accounting from Kansas State University and also earned a Certified Public Accountant designation.
Michael T. Wolverton, CFA
Vice President, Portfolio Manager
Mr. Wolverton is co-portfolio manager of the firm’s Energy and Natural Resources investment strategies, appointed to this role in 2016. He served as assistant portfolio manager to the strategies since 2013. He is also a member of the firm's equity research team, covering energy equipment and services, and oil, gas and consumable fuels.
Prior to joining the organization in 2005 as an equity investment analyst, Mr. Wolverton held an intern position at the firm in summer 2004.
Mr. Wolverton earned an MBA with an emphasis in Finance from the University of Texas at Austin, McCombs School of Business and a BS in Accounting from William Jewell College. He is a CFA charterholder.
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