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17 May 2017Oil Supplies Will Tighten (12:39)
Shawn Reynolds, Portfolio Manager, provides an update on the oil market, and posits that media headlines claiming abundant supply just don’t reflect the underlying fundamentals: “For oil, the current headlines talk about some demand softness and an abundance of supply, but let’s look more closely at the fundamentals....We have had three years of record low oil discoveries, and this will impact supply, maybe not this year or next, but soon.”

Oil Supplies Will Tighten

TOM BUTCHER: I am here today with Shawn Reynolds, Portfolio Manager at VanEck. Shawn, current headlines about oil talk of demand faltering, supply burgeoning. What is the real story?

SHAWN REYNOLDS: It is interesting that the current talk about oil, and certainly the current headlines, all point toward some demand softness and an abundance of supply. But let's talk about the fundamentals, including demand, supply, and of course OPEC [Organization of the Petroleum Exporting Countries].

Demand remains very robust, and this year is expected to be 1.3 million barrels a day. That is quite strong, particularly given that the global economy is not really rumbling along at a very high rate. There has been concern about the growth rates falling, but we should look at the last few years relative to the super cycle years when demand was supposed to be burgeoning. In fact, since 2014 the average rate of demand growth has been the exact same during those super cycle years. So when we talk about 1.3, 1.4 million barrels a day of demand growth it is right on line, or on par, with when we thought that demand was excessive. That's the number one important point. Number two, many of these forecasts that come out start with the IEA, the International Energy Agency. That is the benchmark for forecasting, and many of these forecasts are extremely conservative. The IEA, since 2013, has underestimated its beginning demand forecast by on average 800,000 barrels a day. This means that as we progress through the rest of this year, and certainly into 2018, we are likely to see the oil consumption numbers going up. In particular, looking back at 2013, demand pressure from global GDP was probably on the downside. We are probably seeing a little upside right now because we are seeing kind of a global synchronized growth emerging.

Let's now talk about supply. My favorite thing to say about supply right now is "it's only 5 million barrels a day." What is 5 million barrels a day? It only represents the U.S. shale oil supply, which is only 5 million barrels a day out of, rounding up, a 100 million barrel a day market. Shouldn't we be more concerned about the non-shale, the non-U.S. supply? Yes. If you take 5 million barrels out of 100 million barrels, that gives us 95, and then we take another 30 million barrels out because of OPEC. We are then left with approximately 60-65 million barrels a day of supply, and this supply is under pressure. We are seeing that supply decrease, but that issue is just getting lost by the media amid the headlines focusing on OPEC and U.S. shale production.

What's driving that? I think we need to think about this in both the short term and the long term. Longer term, as we have discussed many times, massive capex reductions have happened over the last several years, representing a reduction in severity and length that has never been seen in the modern oil market. That is starting to show up in terms of resources, not necessarily in production, but in terms of new resources being discovered. Just last week, again the IEA, announced that in 2016 conventional oil, non-shale, discoveries were a mere 2.4 billion barrels a day. That is relative to the 35 billion we consume in any one year. That represents the smallest amount of discovered conventional oil since 1947, and in fact the years 2014, 15, and 16 were sequentially the smallest on record. We have now had three years of record low discoveries. This will impact supply, maybe not this year in 2017 or even 2018, but possibly in 2019 and 2020.

On the shorter-term scale, we are starting to see some impacts on supply because of the oil industry's reduction in capex. We are seeing the impact from OPEC and its quota system. Yes, some of this is being offset by shale growth, but net net it is starting to impact inventory and we are now seeing significant focus on inventories. Inventories, despite what we are seeing in the headlines, are coming down. In March and April we saw global inventories, not just U.S. or not just not one country, fall by 10 million barrels versus a seasonal norm which is a growth, or a build of 19 million barrels. We are starting to see that, and we just had the EIA [U.S. Energy Information Administration], of the Department of Energy, came out and recorded a draw in crude oil, perhaps the largest in the last 15 years of just over 5 million barrels. Yes, we are starting to see more data coming through which supports our supply outlook. Supply is starting to tighten and the outlook is that it's going to get tighter and tighter.

Finally, there is OPEC, and that is the big question. We are facing another OPEC decision on May 25, and we believe strongly, with significant conviction, that the agreement or quota system will be rolled over and renewed. The question is whether it is for another six months, is it longer, does it grow. First and foremost, the quota will be renewed and so that amount of supply, which at this point is close to 2 million barrels a day from its peak back in the fall, will remain off the market for a couple of years.

If you put all of this together, we think that the headlines and chatter about the oil market are somewhat misleading. The fundamentals are staring at us and saying that this market is going to tighten.

BUTCHER: Going back to a point you made earlier, do you see capex continuing to be slashed?

REYNOLDS: No, capex, on a global basis, is probably increasing, but not ubiquitously. Clearly, there has been a big increase in investment here in the U.S. In other places around the world capex is starting to pick back up, but remember it is increasing from a very low level. The increase is happening, but it is not uniform or across the board, and there are some major oil companies where capex is down year over year. Chevron, for example, just announced that it is reducing capex again in 2017. There is some improvement going on, but you're starting from a low base, and as I said those reserves and discoveries that we had in the last couple of years, that is what will feed through into production over the next three to five years, and that is looking very tight.

BUTCHER: Moving on to an economic area, what is your thinking about inflation at the moment?

REYNOLDS: Inflation has done a one-eighty, let's say, in the last year. Now, if you think post-financial crisis, it has just been what is the next crisis? Are we facing another deflationary recessionary environment? Are we going to fall off the cliff again? This time last year, the thinking began to shift. Call it cautious optimism, and the data started to support this more positive view. Maybe quantitative easing on a global basis was helping inflect global GDP on the way up. Certainly, the data started to support that, and this translated into concerns about inflation or reflationary traits. That certainly worked in the second half of 2016, and the early part of 2017. It was dampened a little bit, by some weak disappointing March data, but data again improved in April and now in May.

Certainly, inflation is now part of the conversation as opposed to the last seven or eight years when it was not. Given that it is a concern, we have been looking at the data and analysis, and looked at a number of different inflationary regimes. We divided our analysis into three different inflationary regimes. Inflation below 2%, inflation above 6%, and then that middle range, which we would call normalized inflation, between 2-6%. What we found is that 2-6% range, has been in place for 79% of the time going back to the 1970s. This means that nearly 80% of time we have been in a plus 2% inflationary environment. In that environment, global natural resources equities have outperformed U.S. equities and U.S. bonds. Which is shocking if you really think about it, because really the last 10 years we have been in the sub-2% zone. That is the environment we have been in and natural resource equities have underperformed. We are just now seeing a little bit of inflation, around 2%. That is clearly the target that many central banks have and we may start to see some outperformance. This outperformance won't necessarily go to be straight up, and we're seeing a little pause in it right now, but we expect as inflation continues to grab hold, that we will get back to a market and economic environment that is more supportive of global natural resources equities.

BUTCHER: Do you think investors are becoming more aware of this change?

REYNOLDS: They are certainly much more part of this conversation. The questions that we are getting from our clients are much more oriented towards inflationary regimes, and we have done some interesting analytical work that addresses this.

BUTCHER: It must be quite difficult, because when did we last have inflation that one could talk about?

REYNOLDS: Exactly. But interestingly, we have also looked at the 1970 to the current environment. And we have looked at 2002 to the current environment. And the reason we did that is because we can go after other real asset classes. That would include TIPS [Treasury Inflation-Protected Securities], real estate, also maybe some infrastructure. In 2002 to 2016 natural resources equities again outperformed those asset classes. If you think about 2002 to 2016, have we had a lot of inflation? It doesn't take much. As they say, it takes that kind of 2% cut off. Above 2%, is good for natural resources equities, below it is bad.

BUTCHER: I have one final question. If I'm not wrong, there is another VanEck Natural Resources Conference coming up, isn't there? What is the theme this year?

REYNOLDS: Last year in 2016, our theme was "Surviving and Thriving". This year we are looking at the restructuring that we've gone through, and calling the conference "Reshaped Companies, Revitalized Sectors." If we look at the past couple of years, and all the restructuring that has gone at the industry level and has trickled down to the company level, or maybe vice versa, what do we look like now? It is all very fast moving and not very clear exactly where each company is positioned. There has been lots of competitive movement and positioning, it's going to be very exciting. Last year, we were very focused on the energy sector, which I think was well timed, but this year the Conference will be a more broad based. We are going to look at some gold companies with diversified miners, plus some independent EMP companies, and a drilling company. The day after the Conference we have our field trips, and we are visiting two drilling sites. We see fracking, horizontal drilling, and visit a gold mine. The Conference should be really exciting, and result in some great insight on the big issues facing these industries today.