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Jeremy Baker, Senior Commodity Strategist, Harcourt Investment Consulting

Focus on CapEx cuts to deep-water production

The last six months have been turbulent times for crude oil. On 17 March, WTI futures fell to USD42.63 – their lowest level since March 2009 – whilst Brent crude futures moved close to a six-year low of USD53 a barrel as the market reacted to the potential of Iran raising production on the back of sanctions being lifted. 

On the fundamental side, steady supply growth has led to a glut of inventories in the US, reaching 444.4 million barrels according to the US Energy Information Administration; the highest level since 1982. Many were expecting last year that OPEC would address the production issue as shale oil production ramped up but nothing materialised. The result was a seismic drop in oil price: now some 60 per cent lower than a year ago. 

Jeremy Baker is Senior Commodity Strategist at Harcourt Investment Consulting. “For me it was somewhat perplexing at the time why the market anticipated OPEC would do something. The crude oil price has just continued to grind lower, with no real support, and sooner or later we need to find a price level where there is a balance between supply and demand, as well as marginal cost of production. 

“More importantly, as US shale oil has been a driver of growth over the last few years, the market is yet to determine the marginal cost of production for shale oil,” says Baker. 

Some commentators and analysts are forecasting that crude oil prices could reach USD40 a barrel. Five months ago, Baker would never have entertained that possibility but admits that today anything is possible. 

“The question is, how much is the price being driven on pure fundamentals and how much is being driven by the strength of the US dollar? There is some linkage there. So yes, prices could reach USD40. Would they remain at that level for a long time? No, I don’t think so,” comments Baker. 

The Vontobel Fund – Belvista Commodity has since, the latter part of 2014, been holding longer-dated positions to trade crude oil.

“Rather than having a higher bias to a directional short position we are positioning the conviction trade by using longer-dated contracts due to the significant negative roll yield in the market, which is helping us generate relative alpha. February was a bit of a painful period because of the short-term rally in crude prices, when WTI futures rebounded to USD53/barrel but through the latter part of February, and on into March, we’ve recovered some of those losses as prices have again corrected lower. 

“It is quite hard, when prices are volatile, to trade directionally. The portfolio manager’s bias in the portfolio remains in contract selection. Initially, the portfolio manager was holding 12- to 15-month forward contracts in WTI and Brent but we’ve brought some of that positioning down to six months now,” explains Baker. 

All the big oil production companies are cutting back on capital expenditure and that is going to impact deep-water production. 

“If you cut back on CapEx your conventional oil supply is going to be hurt. That’s what I mean about the market being overconfident; it’s not factoring into account this point. Shale oil is less than 3 per cent of total oil production. 

“We generally believe that crude oil prices should be higher than current levels by the end of the year, excluding any kind of exogenous event,” concludes Baker.

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