"Oil's going higher. We don't have enough. We're in deficit now and the deficit is going to get bigger," said James Brilliant, chief investment officer at mutual fund firm CM Advisors.
Brilliant sounds a little nutty when you get him talking about oil.
"Oil is going to $100," he said. "The most hated part of the equity market is energy, in particular oil, because everyone thinks we're at peak demand for oil. That we have oil as far as the eye can see, but we don't."
On Friday, June 22, the August Brent crude contract climbed 3.4%, to $75.55 a barrel. The contract rose for the week 2.9%. August West Texas Intermediate, the U.S. benchmark, jumped 4.6%, to $68.58 a barrel. It jumped 5.8% for the week to its highest finish in about a month.
Brilliant is the portfolio manager of the CM Advisors Small Cap Value Fund (CMOVX) and the CM Advisors Fixed Income Fund (CMFIX). The Small Cap Value Fund didn't do so well last year, losing 1.4% vs. the Russell 2000 Value Index's 7.8% and the 21.8% in the S&P 500. But in 2016, the fund soared 57.22% vs. the 31.7% in the Russell Value and 12% in the S&P 500. As of June 21, the Small Cap fund is up 10.9% according to Morningstar. The S&P 500 is up 3.8% and the Russell 2000 Value is up 7.6%.
As a fund manager, Brilliant looks for weakness in industries to see if it's a long-term issue or short-term issue. Then he looks at cash flows going forward.
"I think oil has been fundamentally misunderstood, both from a macro standpoint as well as the equities themselves," he said.
Two energy sector small stocks that he likes are Transocean (RIG), the Swiss oil driller, at $12.70 a share, and Britain's Ensco (ESV), at $6.35 a share. He said they're both selling at the low end of their historical valuations, about 30% of book value, "because everyone thinks we're never going to need offshore oil." Book value equals the total assets of a company minus intangible assets and liabilities. Brilliant thinks they should get back to book value, basically triple in price.
Most of the investing world looks at the data coming out of the International Energy Agency, or IEA, to see what the supply and demand is for the world's oil. The IEA serves as a major information source on statistics about the international oil market and other energy sectors. It was formed after the 1973 oil embargo by the NATO countries, tasked with finding intelligence around the energy markets, so an embargo wouldn't happen again. There are now 30 members.
Brilliant said as the key provider of information around the oil markets, the IEA is pretty accurate when it makes estimate for world supply. However, he said its estimates on demand are another story entirely. Of course, when you have to estimate how much oil 100 countries are going to use per unit of gross domestic product, it's easy to see the difficulty in the making a good guess. Brilliant said it's so difficult, that the agency has underestimated demand over the past decade by a million barrels a day.
He blames that on the huge growth of China and India as they rapidly move from emerging economies to developing economies. Their demand for energy is increasing exponentially.
"There's an explosion in demand as income per capita rises," said Brilliant.
He recounts how after China entered the World Trade Organization in 2001 it rapidly increased its economic activity, which increased demand for oil. This demand led to an oil deficit, which pushed the price of oil up to $147 by July 2008. Brilliant says this was one of the less mentioned reasons for the financial crisis. Oil prices fell to $40 by February 2009.
He said China's growth, while unlike the early days, is still strong and India is entering the phase China was entering in 2001.
Brilliant said the IEA says oil demand is going to grow by 1.4 million barrels a day, but as mentioned before, it's been underestimating oil demand by a million barrels a day.
Brilliant said oil inventories are now below their five-year average, and the IEA expects a deficit of 600,000 barrels a day, or 162 million barrels over the next three quarters. He said the last time oil was 100 million barrels below the five-year average inventory, it was more than $100 a barrel.
"The consensus view is we have more oil than we need and oil will remain lower priced for longer," said Brilliant. "However, because oil prices have been lower, cash flows have been down, and energy companies have under invested in their capability to produce future oil production by a trillion dollars over last three years."
He said we're going to need everything offshore to satisfy future demand, The opportunity is in offshore drillers that usually sell at 1 to 2 times book value, but are now selling at 30% of book.
"The whole industry should benefit, but Transocean and Ensco are well positioned," said Brilliant. "In broad terms, the sector in total is down and we think the entire energy sector will become one of the best performing sectors of the next few years."
Date: Jun 25, 2018