Oil industry faces short-term hurricane impact

Ivy Energy Fund

Hurricane Harvey came ashore on Aug. 25, 2017, as the most powerful hurricane to hit Texas in more than 50 years. Recent estimates show 60 persons were killed, more than 1 million were displaced, around 200,000 homes were damaged or destroyed and destruction was spread for more than 300 miles. This overwhelming storm is likely to directly affect those in and around Houston for months and its overall impact may be felt even longer.

Still early for economic impact

It still is too early to know the full extent of Harvey’s economic impact on the Houston area or the U.S. as a whole. Ivy Investments research suggests it may have a slight negative effect on third-quarter U.S. gross domestic product (GDP), but that is preliminary — especially after Hurricane Irma blasted through Florida and several other states.

For all their damage to life and property, history does show that natural disasters ultimately have a net positive effect on GDP because of the rebuilding and replacement that follow. The combined hits of Harvey and Irma are likely to cause a drag on third-quarter GDP, but the fourth quarter and even possibly early 2018 look stronger than otherwise forecast. The combination of the two storms is likely to mean the recovery process will drag on for a longer period. The shortage of labor for construction and home building that has been a headwind for such activity for the past year also is likely to intensify as demand increases.

On Sept. 8, the U.S. Congress approved legislation to suspend the U.S. debt limit and provide $15.25 billion for hurricane relief to help those in Texas and other parts of the Gulf coast. The measure was signed by President Donald Trump on the same day. But the total is only a fraction of the potential need. Texas Governor Greg Abbott estimated damage from Harvey alone at $150 billion to $180 billion, calling it more costly than Hurricane Katrina, which devastated New Orleans in 2005, and Hurricane Sandy, which hit New York City and surrounding areas in 2012. And no solid estimates have been compiled yet for the damage from Irma.

Energy industry feels effects

Harvey’s impact was felt across a wide section of the Houston area’s oil and chemical industries. No refineries in the Houston area reported major damage from the storm, although many were hit with flooding and related storm effects.

An estimated 24% of total U.S. refining capacity was offline, or about 4.7 million barrels per day (bpd) of capacity at the peak. Refiners since then have been working to steadily resume production and many were back online in early September. The estimated shortage of refinery capacity was estimated to fall to 1.5 million bpd by mid-September as refineries continue to resume activities. The risk to supply appears fairly limited from Irma, given that there are no refineries in Florida, although there could be some impacts in the Caribbean on storage and terminals.*

The price of crude oil slumped as demand slowed after Harvey, since refineries could not accept it, while the price of gasoline and other refined products climbed on continuing demand and the reduced supplies. The Lundberg Survey completed Sept. 8 put the average price of regular gasoline at $2.69 per gallon, up 30 cents since Harvey hit. That also was the highest gasoline price since August 2015, according to data from AAA. While the resumption of refining will help gasoline supplies, the impact of Irma across Florida and other states may continue to affect prices through September.

Because both hit the U.S. Gulf Coast, many have looked to compare the impacts of Hurricanes Harvey and Katrina on the oil industry there. We think it’s important to remember two major differences.

First, Katrina made delivery of oil to the Gulf Coast difficult. Many U.S. refineries are in Texas and Louisiana, and most of the crude supply to those refineries at that time was offloaded from the Gulf of Mexico. The U.S. did not have the supply it does now of shale oil being piped or sent via railcars to refineries from the Bakken, Eagle Ford, Permian and other shale regions.

With Harvey, the Eagle Ford basin was hard hit and output was likely to be shut down for up to four weeks after the storm as companies work to resume drilling. Overall, there was less crude oil supply disruption because of shale regions that were not affected by the storm. However, the ability to deliver to refineries is still diminished because of the location of the refineries.

In addition, the U.S. now has a substantial existing inventory, which is greater than the historical average, and that inventory was not in place during Katrina. We think inventories are falling materially now and more quickly than many in the market have estimated previously.

There remained a concern in the market that the U.S. still was producing crude in areas of the continental U.S. unaffected by the storm, but that crude had no place to go because so much refining capacity was offline. That would simply add to already high inventories. Those concerns pushed oil prices lower, but we think the situation will start to work itself out within a few weeks.

At this time, there is plenty of crude oil in the U.S. but not enough refining capacity. The U.S. has 79 fewer refineries today than it had in 1987, but they generally are larger and more productive — on average, operating at about 90% of maximum capacity. The upside is efficiency, the downside is what we’re experiencing — a lack of flexibility.

In addition, switching from refining heavy crude oil (Middle East) to light crude (U.S. shale) is a long process — meaning it can take years, not months. There is an added problem for refineries in the U.S. Gulf states that are set up to receive heavy crude oil, which they now can’t get. Those refineries can’t immediately process the light crude oil from U.S. shale basins.

Chemicals may be ongoing issue

The chemical industry also felt the effects of Harvey. While there also were no reports of damage or failures at major chemical industry plants, there is a danger of lingering effects because of the toxicity of many chemicals.

Thousands of homes were submerged in flood waters after Harvey and that water may have held benzene and other runoff from an area with the nation’s largest concentration of refineries and petrochemical plants. Officials of the Environmental Protection Agency (EPA) still are trying to access and inspect federal “Superfund” toxic waste sites that were swamped by the storm to determine whether contaminants escaped, including benzene and other cancer-causing agents such as cadmium and trichloroethene.

The same concerns exist in Florida after Irma. Prior to Irma making landfall, the EPA had identified and was monitoring approximately 22 current or former sites within Florida's southernmost 100 miles that could pose a risk. As with Harvey, it will take time to determine if there were leaks or other contamination.

Expecting short-term impact

Those living in and around the Houston area — and now in many communities throughout Florida — will be dealing for many months with the aftermath of these devastating hurricanes. We do not underestimate the impact of the loss of life and the extensive property damage.

In terms of the U.S. energy industry, however, we anticipate a relatively short-term impact and no long-term damage. We think most of the affected parts of the industry are likely to return to normal operations by late September and expect the economic impact of the rebuilding across the areas to last for three to six months.

Based on our views, we do not anticipate making significant changes in the Fund’s strategy or holdings in the short term. We continue to focus on high-quality companies with the lowest cost resources, strong balance sheets and best technology. We maintain a bias toward onshore North American shale oil producers and supporting companies.

*Source: JP Morgan North America Equity Research, “Hurricane Harvey Outage Tracker,” Sept. 7, 2017

Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through September 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.