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By David Byrns - May 16, 2018
The energy sector got an extra boost from President Trump’s May 8, 2018 decision to remove the U.S. from the Joint Comprehensive Plan of Action (JCPOA), the Obama Administration deal to restrict Iran’s nuclear program. With little spare production available, the development spurred higher crude and equity prices in the sector that has been a top performer in 2018.
The Global Value Equity team believes the withdrawal from the JCPOA pact and further reimposition of economic sanctions will likely strengthen the already favorable supply/demand backdrop for crude oil. Notably, this event has helped markets recognize the normalized earnings power of many energy companies, driving healthy price appreciation as a result.
Although difficult to predict with exact precision, we estimate the reimposition of sanctions by the U.S. could remove between 200,000 to 500,000 barrels per day of crude oil from the market. Iran is the second largest crude oil producer in Organization of the Petroleum Exporting Countries (OPEC), producing roughly 4 million barrels per day. The sanctions will likely curtail Iran’s ability to bring all its supply to the market. Given the total global supply base is approaching 98 million barrels per day, the impact of the potential supply reduction doesn’t appear all that meaningful (representing only 0.2 to 0.5% of total global supply). However, even with Iran producing at maximum capacity, current crude oil markets are already undersupplied with very few sources of spare production capacity that can come online to help keep oil prices from moving higher.
There is short-cycle shale production capacity in the U.S., but it is logistically constrained due to short-term infrastructure bottlenecks and capacity constraints. Saudi Arabia and Russia have spare capacity, but they want oil prices to rise. Venezuela also has spare capacity, but the national oil company is in complete disarray, with oil production declining to levels not seen in decades. That leaves only a few periphery OPEC countries (the United Arab Emirates and Kuwait, for example) that are beholden to OPEC, and they are unlikely to meaningfully increase output.
As a result, oil prices shot up to the $70 range as markets anticipated the economic sanctions and reduced Iranian output—levels not seen since 2014. Though spot commodity prices are largely above levels justified by longer-term supply/demand economics, any further reductions in supply or positive revisions to projected demand are likely to continue to boost oil prices and energy equities.
As documented in our latest energy sector Market Spotlight, the Global Value Equity team thought the collapse in oil prices from late 2014 to early 2016 led to unsustainable prices. We also believed commodity markets would recover, and prices would reflect economic reality as natural rebalancing mechanisms took hold. Recent fundamental developments, including the reimposition of sanctions on Iran, have so far validated our team’s investment thesis.
Most important, the continued recovery in oil prices has helped many energy holdings significantly appreciate, and we’ve trimmed our energy stock positions in several strategies in an effort to preserve gains. We still maintain overweight positions to the energy sector as we believe the risk/rewards in the energy sector remain attractive relative to other areas of the market. Moving forward, we will remain committed to our disciplined, value-based framework. Should the energy sector continue to outperform the market, we may trim our positions accordingly. On the other hand, if relative risk/rewards in the sector become more attractive, we may increase our exposure to the sector.
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As value investors, we believe the factors that drove down the share prices of many well-managed, energy-related companies are overstated. Energy companies may have the potential to return to historic profitability levels via improved efficiencies and cost cutting, providing compelling opportunities.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.