Greg LeBlanc is senior managing director of Wellington Management Company LLP and co-portfolio manager of Vanguard Energy Fund. On March 3rd, Vanguard sat down with him to talk about the energy markets. Excerpts from the interview are below. The full interview can be read over on the Vanguard Blog.
What drove the steep drop in oil prices?
The market has become oversupplied. High inventories, especially in the United States, indicate that the market is imbalanced. Even though there’s some evidence of production declines in the United States and some other areas, U.S. imports have remained high largely because two OPEC nations (Saudi Arabia and Iraq) increased their production last year.
And much of the U.S. supply increase has come from shale oil, a new source of oil that over the past five years or so has helped to balance the market and meet growing global demand.
The significance of shale oil:
Shale oil refers to a substitute for conventional crude oil that’s extracted from oil shale rock formations. Refined shale oil products can be used for the same purposes as those derived from crude oil. The United States has the greatest abundance of shale resources in the world.
Recent advances in technology, including horizontal drilling and hydraulic fracturing—commonly known as fracking—have made extraction of oil from shale less cost prohibitive (although it remains more costly than the production of conventional crude). These processes have allowed companies to extract shale oil from massive repositories across the United States. It also has rejuvenated the country’s natural gas industry. This has come to be known as the U.S. “shale revolution.”
What’s been happening on the demand side?
Here in the United States, 2015 was one of the best demand years in the last two decades. Miles driven was one of the highest since tracking of this data began, surprising many forecasters, and gasoline demand growth was almost double normalized levels. In China, it’s true that demand growth has slowed for other commodities such as steel, aluminum, and copper. But, and this may also surprise you, gasoline demand in China grew last year in the high single digits. Demand for diesel, more of an industrial fuel, also grew, but at a much slower pace.
What role does the stronger dollar play?
Dollar strength does play a role, because most of the growth in oil demand in the next five to ten years is expected to come from the emerging markets, and with a stronger dollar, oil becomes more expensive in local currency terms. Even so, my view is that oil prices are much more about supply and demand than the dollar.
Do you see a bottom for oil prices?
Yes, we do, because self-correcting forces are being triggered. It’s always tricky to predict the timing of price changes, but today’s price is too low for the industry to work. The financial pressure has become severe; last year there were about 40 bankruptcies, and we expect even more this year if low prices persist.
We’ve seen a significant reduction in rig counts—down almost 70% in North American shale. This retrenchment means lower production in many areas. So the capital cycle is working toward higher oil prices, although inventories haven’t improved yet.
A bottom may be close as low prices are leading to less supply and stimulating demand, which will help prices recover to a more sustainable level.
Is there a historical relationship between oil prices and bear markets?
Commodity prices reflect expectations for both supply and demand, and certainly weak prices may reflect worries about demand and may foreshadow economic weakness. I come back to the importance of China and other emerging markets as demand growth drivers.
As far as the historical relationship between bear markets and oil prices, correlations aren’t very high. Of course, there have been times when oil prices have surprised us by spiking, and that’s been a negative for stocks. But oil tends to have its own cycle, its own volatility—and that can certainly affect countries that are highly dependent on oil exports.
Where are you finding opportunities in this market?
We’re finding opportunities in several of the U.S. resource owners. Shale development and the technology progression signal some pretty interesting futures for some of the companies that were first-movers in capturing high-quality acreage.