Oil’s existential crisis? (3 min read)
Oil has fallen out of favour with investors as geopolitical events combined with Donald Trump’s propensity for interference shrouds its short, medium, and long term future in uncertainty. US sanctions are now in effect across Iran, Venezuela, and Russia, which together account for one third of the world’s remaining conventional oil reserves, and these – particularly those on Iran and Venezuela – have reduced the Organisation of Petroleum Exporting Countries (OPEC) supply by 2 mb/d y/y (2.5% of the global crude market). Meanwhile, tankers have been seized in the Strait of Hormuz, a crucial choke point through which 25% of global oil trade flows.
Such geopolitical tension and potential supply losses would once have caused oil prices to spike. But these are unprecedented times. Oil has been locked in a narrow $60-70 per barrel range for most of 2019 because the market believes that any supply loss from sanctions will be offset by rising US supply and demand destruction – either from a slowing global economy (a cyclical short-term driver) or rising electric vehicle use (a structural medium to long-term driver). In reality, short-term oil demand is slowing, not collapsing, while demographic factors such as the 140 million people joining the global middle class income bracket each year will drive long-term demand.
Doomsday demand scenarios have clouded the outlook for oil
Since the opening shot of the US–China trade war in early 2018, markets have been lurching between deep concern about the destructive impact of tariffs on the global economy—oil demand grew by just 0.9 mb/d across H1 2019, the slowest pace since 2014—and optimism that the US and China are closing in on a ‘historic deal’ that will unleash a flurry of economic activity. Meanwhile, leading economic indicators continue to point to a deceleration in global economic growth, and with the US-China trade war unlikely to cool off in the near term, oil demand growth will probably struggle to rise materially in H2 2019 or even into 2020.
Supply losses have been overlooked
While demand growth has undoubtedly slowed—in fact, we believe 2017’s demand growth of 2 mb/d y/y represents a peak—supply losses are arguably gaining less traction. OPEC, which currently supplies almost 40% of crude oil globally, is on course to reduce supply by almost 2 mb/d y/y this year, which would be the largest decline since the global financial crisis of 2008/09. But supply gets little attention today as the impressive rise in US oil production has fundamentally shifted the mindset of investors from one of supply scarcity to supply abundance.
Oil’s lost decade?
Combining these seemingly contradictory short- and long-term drivers it is easy to see why a non-specialist investor may shy away from an investment in oil. After all, why should an investor have exposure to oil today given that demand may not exist in the future? We agree that over the next two decades, climate action and electric vehicles (EVs) will reduce demand from the road transportation sector. But the EV effect is often misunderstood. We do not expect gasoline demand to peak until 2032, as EVs increasingly absorb market share. Today, internal combustion engines make up 96% of the total vehicle fleet, and this share is set to fall only a small amount to 87% in 2032. EV penetration of the fleet will be slow, if steady.
The back end of the oil curve has struggled to rise above $60 per barrel, which has capped investment in the oil sector. This desire to shun oil is best reflected in the performance of energy equities. The S&P 500 index has doubled since 2012 (some technology stocks have breached $1 trillion since), yet energy equities have yielded a negative return over the same timeframe. While we do not expect oil prices to break out materially from the current $60-70 per barrel range in the very near term—as concerns around the global economy are driving investor sentiment—over the medium term we expect supply pressures to build (especially as supply growth from the US fades), leading prices to move above $80 per barrel. We see limited downside risk for two reasons. The first being active inventory management from OPEC and Russia in addition to demands by investors in US oil producers to display greater capital discipline in the face of lower prices, which will ultimately curb the pace of supply growth. The current rut oil investors find themselves in raises the risk they will miss out on the renaissance in oil after what could become the commodity’s lost decade.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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