Sector Crash

Jim Brown
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Crude prices remained around the $65 level but energy stocks flamed out.

Many stocks were making new 52-week highs the prior week but the excitement faded quickly as soon as US inventories started to build. The API inventories on Tuesday showed a build of 3.229 million barrels and the EIA on Wednesday showed a build of 6.8 million barrels. This was the first inventory gains after 10 consecutive weeks of declines. This is normal for inventories to rebuild starting in January and the cycle was actually two weeks late this year. The next two months should continue to show inventories rising. Investors may have been looking for the first signs of a build to dump positions.

Refineries begin their spring maintenance cycle in February and March and the demand for crude declines sharply. The refinery utilization rate declined from 90.9% to 88.1% last week. That is down from 96.7% on December 29th when refiners were trying to reduce their oil inventories before the property tax deadline on December 31st. That is a huge drop of almost 10% of capacity in just five weeks.

The XLE declined 8% for the week with a 4% drop on Friday after Chevron and Exxon both missed estimates badly. The sector was in dive mode all week.

Ironically, Goldman Sachs made a call for $80 oil within the next six months. Goldman believes the global economy is growing fast enough to exceed current demand expectations by the EIA, IEA and OPEC. While I am not going to be happy paying higher gasoline prices, I would be excited to see the energy sector make new highs again.

OPEC needs to get prices as high as possible before they try to do the Saudi Aramco later this year. They have a lot to gain by keeping the production cuts in place for the rest of 2018.

With US production nearing 10.0 million bpd and inventories rising despite record export levels, the US may actually be confusing the demand picture. There are outages all around the world and the global inventory levels are actually falling rather sharply. Because these inventory levels are not reported on a weekly basis like the API/EIA reports in the US, we ar enot getting the full picture.

This is part of Goldman's call for higher prices. They believe the oil market has already rebalanced. They said there was a global supply deficit of 1.1 million bpd in Q4 due to outages and increased demand. OECD inventories declined about 105 million barrels in Q4 and that put the global inventories back down to the five year average and the OPEC targets. It is not in OPEC's best interest to suddenly begin shouting "inventories are balanced." They want the decline to continue and put inventories in a deficit related to the averages. That way when production is restarted there is someplace to put it and demand to use it.

Goldman said global demand is actually higher than the alphabet agencies are reporting. Low oil prices have built demand all over the globe not just in the major cities. They also said the worry about new production in the US is overblown because there is no way to get that oil to market. Much of the new production is waiting for new pipelines to be completed and that could take 12-24 months.

Goldman said oil demand likely rose by 2.0 million bpd in Q4 compared to the 1.7 mmbpd average for the entire year. The rate of demand growth is accelerating. They are targeting 1.8 mmbpd in 2018 while others have predicted 1.4 to 1.6 mmbpd.

The bank pointed to near 100% compliance on the 1.8 mmbpd of production cuts. This is unheard of. OPEC members never comply and always cheat. This unexpected compliance has accelerated the decline in inventories. Goldman believes Russia will end its compliance in July and put 300,000 bpd back into production. Fortunately, that is about what analysts expect Venezuela to lose in the second half of the year. That country is sliding into oblivion at a high rate of speed.

The analyst is also quick to point out that by the end of 2018 all 1.8 mmbpd of the production cuts will be back on the market. That will depress prices again in 2019. Energy prices are always cyclical. Higher prices increases production, which lower prices and eventually decreases production or at least slows the rate of growth. Eventually demand catches up with production and the cycle repeats.

The cycle is in for a crash in the coming years. Electric cars are becoming more prevalent and the 500,000 expected to be produced this year could rise to 2.5 million a year by 2020. GM has 17 models they will debut over the next five years. BMW, Audi, VW, Mercedes, Nissan, etc are all building electric cars as well as several Chinese brands. While not everyone can afford an EV or will want to give up the convenience of gasoline/diesel powered vehicles, the EV wave is coming. By 2025 there could be 20 million vehicles on the road. That is going to crimp demand growth for oil.

Let's say oil demand growth simply flattened out at 1.0 mmbpd per year. That would still allow inventories to rise by 500-705,000 bpd and the glut will return and this time it will be permanent. The only thing that keeps the oil sector running year after year is that demand growth has always been constant. That allows producers to drill more wells and produce more oil because demand is always growing. At some point in the next decade we will see "peak demand" and that is going to be a major upset for the energy sector.

Currently there are somewhere around 50 million fueled vehicles manufactured each year. If that number begins to decline as the number of electric vehicles increase, the demand for crude will actually begin to decline. I believe Saudi Arabia has figured this out and that is why they are rushing to do their IPO. Five years from now the outlook for oil could be significantly different and by 2030, the industry will be in decline. That is a sobering thought after 100 years of constant growth.

Active rigs declined by one last week but that number is misleading. Oil rigs rose by 6 and gas rigs declined by 7. Offshore rigs declined by 2 to 17 and the cycle low. Producers are not racing to drill more wells despite the $65 oil. I believe they realize the next couple of months could see prices decline before rising again for the summer. Active rigs are still well below the 1,900 plus in early 2015. At only 946 today that is only half and production is significantly higher. With more than 7,000 wells drilled but uncompleted, there is plenty of production ready to come online if prices were to spike over the summer.

The market meltdown may have run its course. We will not know until Monday's close but the S&P futures opened on Sunday night at -19 and have improved to -4. There is likely to be some forced margin selling at the open and maybe some follow through from Friday, but too many people have been waiting to buy a dip. I just hope they buy the dip in energy stocks.

Jim Brown

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