For the broader market, we’ve long followed a concept we call the “volatility smile.” Simply put, broader stock market volatility is high early in the stages of a bull market, falls to low levels in the middle of a major rally and then rises again in the latter stages of a bull market. And, of course, volatility usually rises sharply during a bear market.
A similar pattern is apparent in energy stocks. The S&P 500 Energy Index and the Alerian MLP Index have experienced breakneck volatility so far in 2018, tracing a jagged recovery from the vicious mid-2014 to mid-2017 bear market for the group. In fact, energy stocks in the S&P 500 ranked near the bottom – 9th out of 11 S&P Economic Sector Indexes – in first quarter 2018, only to rebound to rank as the top-performing group by a wide margin in Q2 and, once again, dead last so far in Q3.
At the MLP and Energy Infrastructure Conference in Orlando last May, Master Limited Partnership (MLP) industry veteran Randy Fowler of Enterprise Products Partners commented that sentiment on the midstream partnerships this spring was the most negative he’d seen since 1999. Then, as now, industry fundamentals were rapidly improving; yet, the stocks were not being rewarded accordingly and investors were instead reaching for momentum in the technology sector.
One example of this pessimism was the panicky 10% intraday slump in the Alerian MLP Index back in March in reaction to a FERC decision on income tax allowances in cost of service rates, guidance that impacted only a small number of MLPs and just 5% to 7% of total industry cashflow.
At the time, we commented that this looked like a classic sign of overreaction and the MLP bulls “throwing in the towel” on the group, just the sort of market action and volatility that tends to accompany major market lows. Sure enough, since the end of March, shortly following that FERC-driven sell-off, the Alerian MLP Index has jumped more than 21%, one of the strongest 5-month returns in the history of the index.
Simply put, this energy sector volatility is characteristic of a group near a major low and we believe that’s the case with the energy patch today.
The chart above shows the price-to-book ratio for the S&P 500 Energy Index since the beginning of 1996. Currently, the index trades at just over 2 times book, a near 1 standard deviation discount to the long term (1996 to 2018) average near 2.45 times book. And, valuations are just rising from near 30-year lows under 1.5 times book (about 2 standard deviations below the long-term average).
While it’s undoubtedly a simplistic way to look at commodity prices over the long-haul, our chart of Brent oil prices over the same 22-year time frame shows that Brent prices near $80/bbl are more than $20/bbl above the long-term average of $56.70/bbl. Thus, valuations in the energy sector remain well below the long-term average while the commodity price backdrop is strong and improving.
Our conclusion remains that sector valuations have not yet climbed to reflect the realities of the recovery in oil to the mid to upper $70’s per barrel level from lows in the mid-$20s just over two years ago. And MLPs have not yet risen to reflect the massive opportunity ahead to build out the pipeline and processing infrastructure needed to serve fast-growing shale fields like the Permian Basin of west Texas and New Mexico.
This summer, WTI and Brent oil prices endured corrections of 14.5% and 12.5% from their 2018 highs respectively.
Our view remains that this pullback is little more than a correction after a big run-up in energy prices from the summer of 2017 through the spring of this year. It does not appear to be the beginning of a new bear market in oil.
This chart shows US oil inventories compared to 5-year maximum levels, 5-year minimums and the 5-year average. As you can see, US oil inventories began 2018 somewhat above the 5-year average only to fall through that average level by April – this was the first time since 2014 that US oil inventories fell below the 5-year average by a significant amount and it helped drive WTI’s run-up to $75 and Brent to over $80/bbl by July and May respectively.
The most obvious catalyst for the summertime correction in crude: US oil inventories rose counter-seasonally in July and early August. In other words, US oil inventories historically fall sharply in July and August because it’s the heart of summer driving season and refineries are working hard to produce enough gasoline and diesel to meet demand.
This year, while refineries were working flat out – refinery utilization peaked at 5-year highs of 98.1 percent in early August – US oil inventories stopped falling in early July and rose slowly above the 5-year average by early August. That spooked the market, leading to concerns that global oil demand growth might be faltering or that global supply was, once again, rising too fast as OPEC eased production constraints at their June meeting.
This chart of the four-week moving average of gasoline demand clearly shows both seasonal and a long-term trend in gasoline demand over the past 12 years. As you can see, US gasoline demand rises in the summer months during driving season.
The longer-term trend shows that demand was weak from 2010 through 2014 – the clear pattern of lower highs and lower lows over this period – followed by strong growth in gasoline demand from 2015 through 2017.
This is a function of the pattern in prices over this time. Average US retail gasoline prices slumped from $3.70 a gallon in April 2014 to a seasonal peak of just $2.80 a gallon in the summer of 2015 and $2.40 a gallon over the summer months in both 2016 and 2017. US drivers took advantage of this decline in gas prices, resulting in a surge in demand in the 2015 to 2017 period. This also likely reflected pent-up demand for road trips postponed during the high gas price environment that prevailed through most of the 2010 to 2014 period.
In contrast, this summer average retail gasoline prices peaked at just under $3/gallon in late May, reflecting the jump in oil prices over the past two years. Predictably, the rise in prices worked to moderate gasoline consumption over the past few months.
However, it’s easy to overstate this impact. After all, peak demand for gasoline this summer was around 9.7 million barrels per day, down just 62,000 barrels per day from the peak demand in the summer of 2017. Meanwhile, gasoline demand this summer has been well above the 9.0 to 9.2 million bbl/day level that was the norm back in the peak of summer driving season in 2013-14.
In short, US gasoline demand remains healthy and near recent seasonal highs, albeit slightly down compared to 2016-17 due to higher gasoline prices. Moreover, it’s tough to argue that a 62,000 bbl/day decline in gasoline demand could account for the observed pattern in US oil inventories thus summer.
A more likely culprit: A surge in Saudi oil production early this summer that resulted in a jump in US oil imports from the Kingdom in July and August.
US weekly oil imports from Saudi Arabia averaged around 1 to 1.2 million bbl/day through 2016 and the first half of 2017, only to contract to multi-decade lows late last year and early in 2018. This was part of a concerted Saudi effort to drive US oil inventories – the most visible and highest frequency measure of global oil market balances – below their 5-year average levels.
However, over the past few months US oil imports from Saudi have steadily recovered back to the 800,000 to 1 million bbl/day range. We believe that this also reflects a conscious policy on Saudi Arabia’s part to prevent oil prices from rising too far, too fast this summer with the consequent risk of a price shock that negatively impacts global oil demand. Saudi policy was also likely influenced by unplanned production outages in countries like Venezuela and Libya this year as well as criticism of fast-rising oil prices from US President Donald Trump.
Regardless of the main rationale for boosting exports to the US, we see Saudi and US interests roughly aligned at this time. Neither side relishes a return to the depressed oil prices of 2016 and early 2017, particularly given the growing importance of the energy industry (shale) to the US economy. Nor does either side truly want to see a spike to $100/bbl crude – while that would bring a short-term windfall for Saudi Arabia’s finances, the longer-term impact on demand and the global economy would likely offset any short-term boost.
The shape of the oil futures curve is a solid barometer of short term supply-demand conditions in the global oil market.
When the Brent oil futures curve slopes up, the market is said to be in contango. This means that the front month price of oil (the futures for delivery closest to the current date) is lower than futures priced for delivery 6 or 12 months in the future. As a rule of thumb, when the oil market is in contango underlying supply/demand conditions are bearish.
Markets in contango also encourage commodity storage and a build in global inventories. That’s because a trader can buy oil at low spot prices (oil for immediate delivery) and simultaneously sell oil futures for delivery in 6 or 12 months’ time at higher prices. Provided the cost of storing oil for the term of this trade is lower than the degree of contango in the futures market, this trade realizes a risk-free profit.
In contrast, when the oil futures curve slopes down – front month prices higher than oil for delivery in the future – the market is said to be in backwardation, which is bullish for crude oil prices.
Our chart above depicts the price of Brent crude priced for delivery 12 months in the future less the front month futures price. Thus, a negative number indicates backwardation and a positive number, contango. As you can see, the Brent market flipped into backwardation roughly one year ago; in fact, this was one of a handful of conditions we were watching that turned us more bullish on crude in the summer of 2017.
And, while the market never came out of backwardation on this basis this year, the curve did flatten (the degree of backwardation lessened) from late April until late July and that period corresponds to the 12% to 15% correction in oil prices we noted earlier in this issue.
However, note that the curve has steepened further into backwardation since late July. That’s consistent with our view that the summertime weakness in oil prices was a correction, due to the temporary increase in Saudi imports, rather than the beginning of a more sinister loosening in market supply and demand fundamentals.
Against that backdrop, our outlook is for oil prices to remain well-supported around $65/bbl for WTI and $70/bbl for Brent for the remainder of 2018. The biggest risk for oil priced into early next year is to the upside – should Venezuelan production continue to fall and countries like Libya, Nigeria, Mexico and Iran see continued output declines or ongoing temporary outages we believe Saudi Arabia would need to cut deeply into spare capacity to meet global demand. That could lead to concerns about the world’s shrinking supply cushion and a spike towards $100/bbl.
The biggest downside risk to crude is on the demand side in the form of a global economic slowdown that causes growth in consumption – a tailwind for oil prices — to slow meaningfully. However, most of the economic indicators we watch, including the US Leading Economic Index (LEI) we’ve highlighted in Energy & Income Advisor on several occasions, suggest low-risk of a US downturn over the next 12 months.
All told, we see Brent likely to trade in a range of $70 to $85/bbl and WTI in a range of $65 to $80/bbl. The risks look skewed to the upside (higher oil prices) for early 2019. Perhaps the biggest upside risk remains the ongoing decline in Venezuelan output as the economy enters a phase of outright collapse and hyperinflation.
For more on global energy markets and 5 profit steps we’re recommending right now, check out this presentation, available with my compliments, by tapping here: