It has been a perfect storm on both the demand and supply side for the oil market since late last year with Geo-political tension, supply chain issues and the re-emergence of business/leisure travel. As oil prices have fallen 30% from peaks of $139.13 Brent and $130.50 WTI in March, is now the time to be buying the dip or does it have further to drop? There is a lot to potentially discuss, but below I have tried to highlight what I see as the key issues going forward.
On the supply side, it appears OPEC+ have exhausted their spare capacity. OPEC+’s production cut “curtailment” strategy in response to the pandemic (Apr20) formally concludes in August. This is the critical event that may shine a light on the lack of global spare capacity. A few weeks ago the group met and agreed to an increase of 0.1mmbbl/d in September, one of the smallest since OPEC quotas were introduced in 1982. OPEC+ sources say the group has 2-2.7mmbbl/d of spare production capacity that will be held in reserve for winter supply disruptions.
OPEC+ (and non-OPEC) producers are suffering from chronic upstream underinvestment, which was highlighted in the meeting a few weeks ago. It’s questionable that there is even ~1mmbbl/d short-term spare capacity compared to current production levels. Saudi Arabia is understood to have 0.5-1.0mmbbl/d spare capacity while currently producing 10.4mmbbl/d. Looking at historical data, Saudi has never recorded sustained actual oil production of more than 10.5mmbbl/d (2H16). The March 2020 ‘supply highs’ of over 12mmbbl/d were not actual production but rather production plus the use of oil inventory.
In the US total petroleum inventories have drawn-down 110mmbbl. The YTD drawdown is almost entirely attributed to the SPR (strategic petroleum reserve). The YTD crude drawdown of 124mmbbl is effectively an additional producer in 2022. On a longer-term view, the SPR will need to be replenished; it is currently at 37-year lows. The indications are that of stocks will be replenished after FY23. The US DOE has stated, “Oil purchases to replenish the SPR will not be competing with demand for oil in the near term.” Thinking of the SPR as akin to a producer, US inventories are broadly flat since the start of the year. The SPR is not a quasi-producer indefinitely.
On the demand side there has been a weak US gasoline driving season this summer (the US consumes ~35% of global gasoline). To add to this we have seen a forced reduction in airline operations, with the likes of Heathrow airport significantly reducing landing slots. Locally Qantas cancelled ~8% of flights in July due to staff shortages, both trends are mirrored throughout the rest of the industry. It is unlikely that both of these phenomena will last over the medium/long term.
We are also seeing a rise in sale of electric cars which will reduce the transportation sector’s reliance on fossil fuels. There are normally around 67-75m cars sold each year, with around 9.5m of those predicted to be EVs this year (last year around 6.75m cars were sold). The existing global fleet of cars is around 1.4 billion, so put into perspective, EV production and existing stock proportions are very small at this stage.
There has been some discussion about a US-proposed Russian price cap, but in reality, could it work? Conceptually, a price cap – if fully and successfully implemented – would be bearish, as it would keep oil flowing while simultaneously achieving Europe’s aims of limiting Russian revenues. Such a scheme benefits from being less blunt than an outright ban in terms of the physical disruption, as well as offering better political incentives via its flexibility. The key risk to this policy, however, is the potential for Russian retaliation, similar to what has occurred on EU gas, which would turn this into an additional bullish shock for the oil market. Even if China and India do not formally participate in such a price cap mechanism, they would likely de facto engage in it by offering to purchase barrels only slightly above the cap. Personally, I think it would be very difficult for such a price cap to be implemented at all, and even if it was, surely it would take some years to go through any negotiation process.
Now to have a look at the oil-related equities. While a global recession appears to be on the horizon, if history is anything to go by, energy has been the worst performing index by some way during previous EPS contractions. Some would expect, the sector will perform better this time around assuming there is a soft landing rather than a deep structural recession. Recent results from oil majors, BP and Inpex, led to both increasing their dividends and buybacks. The sector should have some medium-term support stemming from these types of capital action if a broader selloff was to occur.
Despite all the negativity around oil demand, US inventories have been broadly flat this year and had been significantly drawn down for several years. A large supply side response is required to reverse the trend of global inventory drawdowns. From August, the supply side response can’t come from OPEC+. To add to this, there is the increased risk of geo-political issues, increasing demand from China and the annual supply risk from the upcoming hurricane season can only drive the price of oil higher from here. On balance, the recent pullback could be an opportunity to add to equity positions.
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