When oil is trading at US$20–US$30, many energy companies are not profitable. When oil prices are that low, companies are operating simply to cover their cash costs – it can be very costly to restart a stopped oil well and companies stand to lose less money by continuing to produce, rather than ceasing production altogether.
Oil at US$30 per barrel implies that we’re going into negative-growth territory on oil demand, and that’s just not the case right now. Our research, including some of the recent data out of China and numbers released by the International Energy Agency (www.iea.org) seem to verify this belief.
Why oil prices should normalize
Oil companies globally slashed their capital expenditure (CAPEX) budgets last year and the cuts are continuing into 2016 at unprecedented rates. The U.S. rig count has dropped off dramatically in the last twelve months. At 2015 year-end, the count was 698 and as at April 1, 2016 it stood at 450. The current level represents a 75% decline since 2014 year-end.1
It can take roughly 12 months from the decision to drill to revenue recognition from production. What some industry-watchers fail to realize is that while it’s easy to put a rig out of service, it is very difficult to get it up and running again.
There are two reasons for this:
- Oil-field workers impacted by the structural unemployment that is rampant throughout the industry likely can’t afford to wait until Q2 of 2017 to be rehired. Many will move on to new opportunities in related fields
- As companies seek to minimize their working capital, many of the rigs that have been put out of service are being stripped of valuable parts for use on other rigs that are still in service. These fleets are not operationally ready should prices rebound
No market participant – Saudis, Russians or U.S. shale frackers – wants to be the first to shut production and lose market share. The majors have focused on stabilizing base production, but without meaningful investment, production declines are likely and inventories will eventually begin to decline.
Loss in momentum of the U.S. dollar
The U.S. dollar (USD) has lost some of its momentum so far in 2016. Historically, there’s been an inverse relationship between crude oil and the USD (i.e., when the USD trends upward, oil trends downwards and vice versa).
Some reasons for this include:
- Oil is priced in USD. Therefore, when the USD is strengthening relative to other foreign currencies, oil becomes relatively more expensive for foreign buyers, which negatively impacts demand
- Commodity prices are negatively impacted by recessionary fears in global markets as investors seek the relative safety of the USD
Balance-sheet risk in the energy sector
Many of the super majors, which we don’t own, such as Chevron Corp., Exxon Mobil Corp., Royal Dutch Shell PLC and BP PLC, have yet to slash their dividends. However, these companies are debt financing a large portion of their committed dividends while cutting CAPEX. Coming out of a downturn, these actions can make it more difficult to add to production as a significant amount of capital related to future projects has already been deferred or canceled.
Fund positioning in a low-oil-price environment
We don’t need oil to go back to US$70 per barrel for us to get excited about opportunities in today’s market. We believe there is upside in the portfolio if oil gets to US$50 per barrel. Overall, we’ve been adding to quality companies that we believe are going to survive this period of extremely low commodity prices.
As at March 31, 2016, the cash weights in Trimark Resources Fund and Trimark Energy Class were 1.5% and 6.7%, respectively. Cash weightings have come down recently as we’ve added to existing holdings and established new positions. We’ve deployed significant capital into U.S. exploration & production names, which we believe offer investors exposure to unconventional oil plays at more attractive valuations and better risk/return profiles at this stage in the cycle.
Our hedging activity is very much tied to the price of commodities. We won’t hedge currencies that have a strong positive correlation to commodities, such as the Australian dollar. As it stands, we’ve hedged over 75% of our USD exposure on both Funds.
Oil prices dropped to more than 12-year lows on February 11 of this year. Since then, Trimark Resources Fund (Series F) and Trimark Energy Class (Series F) have returned 25.68% and 23.65%, respectively (as at March 31, 2016), outperforming their benchmarks, the S&P/TSX Composite Index (Energy and Materials weighted) and the S&P/TSX Energy Index, which returned 17.35% and 19.75%, respectively. We believe that the bulk of this outperformance can be attributed to our focus on owning quality companies an eye on the long term.
1 Source: Bloomberg L.P. and Baker Hughes U.S. Rotary Rig Counts.
All data is provided by Invesco Canada unless otherwise noted.
An investment cannot be made in an index.
The above companies were selected for illustrative purposes only and are not intended to convey specific investment advice.
Trimark Energy Class, Series F, provided the following performance returns as at March 31, 2016: 1-year, -31.59%; 3-year, -17.41%; 5-year, -13.40%; and since inception, -12.03%.
Trimark Energy Class, Series A, provided the following performance returns as at March 31, 2016: 1-year, -32.82%; 3-year, -18.30%; 5-year, -14.35%; and since inception, -12.98%.
Trimark Resources Fund, Series F, provided the following performance returns as at March 31, 2016: 1-year, -23.56%; 3-year, -14.48%; 5-year, -11.68%; and 10-year, -0.82%.
Trimark Resources Fund, Series A, provided the following performance returns as at March 31, 2016: 1-year, -24.76%; 3-year, -15.77%; 5-year, -12.95%; and 10-year, -2.13%.
The S&P/TSX Energy Index provided the following performance returns as at March 31, 2016: 1-year, -22.50%; 3-year, -8.00%; 5-year, -7.44%; and since inception, -3.69%.
S&P/TSX Energy & Materials Weighted Index provided the following performance returns as at March 31, 2016: 1-year, -12.46%; 3-year, -6.83%; 5-year, -9.13%; and 10-year, -0.51%.
Note: Series F is available only to advisors who have signed an Invesco Series F dealer agreement.