The article from the Wall Street Journal (click here) sheds some light on how oil demand and supply are calculated, often incorrectly. The International Energy Agency (IEA) is the trusted entity responsible for the headlines over the past year of a “global crude oil supply glut” that has sent prices tumbling from over $100/barrel to less than $30/barrel in the past 18 months. According to the IEA, the world has produced nearly 2 million barrels/day more than has been demanded over the past few years causing rampant downward speculation in oil prices. This, however, may not be the case as the article suggests. Supply numbers tend to be more accurate than demand numbers because companies and countries count barrels produced and their associated revenues fairly carefully, however the thought of someone tallying every barrel produced around the globe on a monthly basis is somewhat ridiculous when you really think about it. Demand numbers are far less concrete given they are estimated based on GDP growth in real time rather than physical demand for all the end products that crude oil gets refined into. When you consider how “manufactured” GDP numbers are in countries like China (the second largest oil consumer in the world), you can start to see how oversupply figures might be inaccurate. GDP growth and oil demand are linked to be sure, but the strength of that relationship depends on a myriad of other factors that change over time.

At the end of the day this “2 million barrel/day oversupply” number has caused literally trillions of dollars to change hands around the globe as investors frantically tried to reposition for this new world of never-ending oil supply and ever-withering demand. This is a plague of a modern financial society that desires to continually get ahead of events and justify positioning based on data that seem scientific in the moment but likely sacrifices accuracy for speed. In order to combat this bias, my training at Leon Frazer leads me to taking a wider lens view of the fundamentals before dramatically altering our long term investment view based on very recent “facts”.

Here are the fundamentals we have been following that have caused us to stay the course with oil producers for a portion of the portfolio during a tumultuous last few quarters:

  • Oil demand continues to grow, and growth has only increased during this period of lower prices as would be expected
  • Despite slowing Chinese GDP growth, annual auto sales have doubled since 2009 and road construction continues, this represents increased demand that isn’t likely tied directly to the direction of their economy
  • Other developing nations such as India have also seen auto sales increase dramatically in recent years
  • U.S. auto sales set a new all time high in 2015, V8 engines were the top seller, and gasoline demand also set a new all time high in 2015
  • Global inventories have been rising around the globe signaling oversupply conditions, however the drop in prices should be more than sufficient to rebalance the temporary oversupply
  • U.S. shale oil has added nearly 5% to global oil supply over the past 10 years, however this resource is shorter term in nature (~10-15 years of reserves at current production rates) and comes with dramatic declines that will be evident in a period of weak investment
  • Major oil producers including Saudi Arabia, Russia, Iran, Iraq, Nigeria and Lybia were experiencing financial difficulty BEFORE oil prices dropped and have incentive to manage prices higher longer-term
  • Canada represents 50% of non state owned oil reserves globally (over 50 years of supply at current production rates)

The fundamental picture is always too complex to be summarized into one number. The global production, refinement, and consumption of oil extends literally to every corner of the world, 24 hours a day, 365 days a year. Overconfidence bias is one of the worst enemies of any investor… just ask Bill Ackman… and today’s plethora of data only fuels that bias to trade on short term information alongside the herd. At Leon Frazer we keep a keen focus on the horizon and the fundamentals that matter. Long-term returns aren’t made in a year and they aren’t lost in a year either. We do our very best to remember that we are not smarter than the market and we can’t anticipate its direction. We are just trying to fractionally participate in the companies that supply essential goods or services to Canadians and the rest of the world. Patience is in short supply, therefore the value of having it continues to rise.

 

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