AKAAF - IEO: US Inventory Replenishments Could Lead To Resumed Mandated Supply Cuts

2024-01-08 12:10:15 ET

Summary

• The iShares U.S. Oil & Gas Exploration & Production ETF is heavily exposed to E&P, making it commodity-exposed.
• The outlook for refineries is stable, with capacity being structural and potential benefits from China's reduced refined product exports.
• More importantly, geopolitical factors, such as OPEC supply cuts and US inventory replenishments, are likely to support oil prices, offsetting any potential demand issues.
• We are bullish on oil but prefer single stocks to IEO which is not very efficient due to expense ratios and the portfolio nature of E&P companies already.

The iShares U.S. Oil & Gas Exploration & Production ETF ( IEO ) is substantially exposed to E&P by almost 76% which is in turn exposing IEO to commodity price changes, upon which these companies depend in price. We have a view on oil, which is that the prices are going to go up towards the end of the first quarter of 2024 and be relatively resilient otherwise through the quarter. In other words, we don't see much downside in oil.

Quick IEO Breakdown

The sectoral breakdown is quite granular and is as follows:

E&P is at 76%, while refinery is at around 24%. As it's more marginal, let's get refineries out of the way. Capacity in refineries is structural. Last year, there were shocks to supply, namely the loss of Ural capacity in Russia as well as retired capacity turned into biodiesel refineries elsewhere. Lately, it is China limiting exports of its refined products as they do run-cuts. This could be good for global refiners outside of China. Otherwise, crack spreads depend on demand for refined products. This is maybe on the shakier side due to macroeconomic concerns, but at least there is a slight supply-side lift. Overall, stable outlook here.

E&P is where things get more interesting, as our thesis is highly geopolitical. Gulf states and other OPEC countries have undue leverage on US politics and are using supply cuts to pressure the current US administration. This has both major sovereign wealth benefits and political benefits. Another thing is that discussions of peak oil or energy transition have been dulled by the obvious need we all have for oil, which means less stranded asset risk, and less race to deplete reserves as their value should hold long-term.

We believe the Guyana situation could limit benefits from the easing sanctions on Venezuela , which have made the oil situation a little less tight. The probability of war here is highly likely. Moreover, tensions in the Middle East mean there is virtually a 0% chance that anything will be done to help Iran's oil reach the global markets.

There is one other major consideration also playing in favor of the oil price. The US inventories of crude were well below expected figures. This means that the voluntary supply cuts by OPEC , which was seen as bearish for oil since it's not mandated but just voluntary , will see the slack picked up by the US as they replenish their reserves. In the meantime, a bone is thrown at OPEC countries that want to produce higher rates of oil to profit off the forced buying from the US. The moment those reserves are replenished, OPEC can come off the break and start cutting again, which again for geopolitical reasons we believe is highly likely.

Bottom Line

Oil prices are somewhat languishing. Demand is weakening due to the global tightening regime, and PPIs are coming down as the massive supply shocks become digested by the global economy and the exceptional operating conditions of industrial producers come to an end. OPEC supply cuts switching to a voluntary basis has been the latest bearish news, as has the calming down of escalation concerns in the Middle East, which were the highest just following the beginning of the war between Israel and Hamas.

The bottom line is we think the increment sees bullish news. US inventory buying and then resumed supply cuts would be a likely push on oil prices to the upside. The only real downside is on the demand side as we may see a shallow recession, but due to OPEC's geopolitical objectives, we believe they will make sure that supply cuts offset any demand issues.

The IEO expense ratio is 0.4%, which is a little high even for a narrow portfolio due to the fact that the sector is highly liquid, indexed, and followed. The segment average according to FactSet is 0.38%, which is a little more efficient.

Nonetheless, we like E&P at the moment. Although we'd prefer to select picks over the IEO ETF - look at our coverage on Aker (AKAAF).

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