Higher for longer?
Oil prices surged to a six-month high in early April, underpinned by both OPEC production cuts and demand being stronger than the market expected thanks to resilient economies, particularly in the U.S. The ongoing conflict in the Middle East has also given rise to a risk premium.
The fundamentals of the oil market today are strong, with the Organisation for Economic Cooperation and Development’s oil inventories below their five-year average. The U.S. Energy Information Administration expects that over the summer months, global oil production may not meet consumption, which tends to stay strong due to the driving season and surging air conditioning demand in the Northern Hemisphere.
Going forward, some opposing factors may affect global production, which has already been restrained by the 2.2 million barrels per day production cut OPEC put in effect in January 2024:
- The White House’s reimposition of sanctions on Venezuelan oil, as the Biden administration asserts that the Maduro government has failed to make progress on free and fair presidential elections, cracking down on the opposition.
- Helima Croft, Middle East expert and RBC Capital Markets, LLC’s Head of Global Commodity Strategy, expects the reimposition of sanctions to have limited impact. She believes the U.S. will grant direct licenses on a case-by-case basis to international companies seeking to bring Venezuelan barrels to the U.S.
- Saudi Arabia may gradually return some of its cuts to the market in the summer, to secure the benefits from higher volume at a favourable price, and perhaps to help key customers. Still, RBC Capital Markets doesn’t expect OPEC to make a concerted effort to increase production unless there is a sustained supply outage. The cartel learned a painful lesson in 2018 when it ramped up oil production to offset an expected disruption in Iranian production. That shortage never materialized, and prices retreated, hurting OPEC’s profitability.
Sustained supply shortages could, however, result from the recent military actions in the Middle East.
Oil prices on the rise?
Price per barrel of West Texas Intermediate (WTI) and Brent crude oil
The line chart shows the price per barrel of West Texas Intermediate (WTI) and Brent crude oil since December 2021. During the period shown, WTI reached its highest price of $123.70 per barrel in March 2022 and its lowest price of $66.48 a year later in March 2023. At the beginning of January 2024 the price of WTI was $70.38; it subsequently rose to $86.59 in early April, and is now just below $83/bbl. Brent reached its highest price during the period of $127.98 on March 8, 2022, and its lowest price of $71.84 in June 2023. It started 2024 at a price of $75.89, peaked in early April at $91.17, and is now at $88.35.
Source - Bloomberg; data through 4/24/24
Clear and present danger
Geopolitical risk has been heating up since last autumn, and flared up in April. After decades of clandestine and proxy warfare, Iran and Israel launched direct military strikes on each other’s territory. While Israeli and Iranian leadership both seem to have designed their military actions to avoid causing significant civilian casualties and infrastructure damage, Croft contends the underlying regional dynamics remain destabilizing and could take sudden escalatory turns.
She notes that a direct threat to regional oil supplies is possible in an expanded war scenario, through attacks on tankers in the Strait of Hormuz or on critical energy infrastructure in the region by Iran or Yemen’s Houthi rebels that it backs. Iran has already threatened to disrupt shipping in the Strait of Hormuz as part of its strategic response to the Israeli strike. In fact, Iran seized a vessel in those critical waters hours before its drone and missile strike on Israel. In 2019, Iran targeted tankers in this crucial maritime passageway that carries the equivalent of 40 percent of OPEC production.
Croft’s view is that current oil prices do not reflect the extent of the escalation risk, even though they are elevated and already reflect a risk premium. She believes a sustained de-escalation of tensions in the region is unlikely. In addition to the potential for Israel-Iran clashes to widen, she also cites the potential for escalation in the cross-border conflict between Israel and Iran-backed Hezbollah in Lebanon.
If U.S. prices at the pump surpass the psychological threshold of $4/gallon nationwide, RBC Capital Markets believes the White House may release more oil from the Strategic Petroleum Reserve (SPR) in an attempt to cap prices during the peak summer driving season and ahead of November’s presidential election. Also, RBC Capital Markets thinks the SPR’s relatively low level of just over 350 million barrels, compared to over 600 million in early 2022 before Russia’s invasion of Ukraine, and elevated oil prices may spur the White House to ratchet up diplomatic efforts to effect a reversal of OPEC cuts at the cartel’s next meeting in June.
Capital discipline energizes Energy equities
Global energy share prices are up more than 10 percent since the beginning of the year, buoyed not only by surging oil prices but also by underlying fundamentals.
In recent years, faced with the threat of the energy transition, oil companies have become more circumspect in allocating their capital expenditure programmes, focusing only on the most profitable projects—whether they are in the traditional oil industry or renewables. Production from the global oil majors has grown only by low single digits, but overall profitability seems well underpinned, in our view. The return on equity ratio has increased to 14 percent compared to the 44-year median of 12 percent, according to Paul Danis, head of asset allocation at RBC Brewin Dolphin.
Going forward, Canadian oil companies have the additional benefit of the long-awaited Trans Mountain Pipeline Expansion (TMX) coming on stream in Q2 2024. The pipeline system will carry crude and refined products from Alberta to Canada’s West Coast, providing oil producers with the ability to reach new markets.
Oil companies’ new capital discipline has enabled most producers to focus on improving returns to investors via share buybacks and dividends. The global Energy sector currently possesses a 12-month trailing dividend yield of 3.6 percent, well above the 2.3 percent yield for the MSCI All Country World Index (MSCI ACWI).
Even after the recent rally in Energy stocks, the global sector currently trades at a 36 percent discount to the MSCI ACWI on a 12-month forward price-to-earnings basis. According to Danis, this reflects a challenging structural growth backdrop driven by the shift away from fossil fuels and the rise of clean energy.
Oil companies can provide a hedge against geopolitical risk and a possible supply shock, in our view. The sector strongly outperformed the broad equity market during the three oil supply shocks since the 1970s.
However, investors should be mindful that oil stocks are not very sensitive to interest rates given their low valuation multiples, and have thus done relatively well in the rising inflation and interest rate environment. If, as we believe, bond yields are close to their peak, this performance tailwind may well be removed. Moreover, by realizing substantial profits thanks to prudent investment in their core businesses, oil companies in Canada, the UK, and Europe risk becoming targets again for further windfall taxes. This could affect investor sentiment.
Weighing the opportunities and risks, we suggest portfolios should have a position in Energy stocks at least in line with relevant equity benchmarks given undemanding valuations, ongoing capital discipline, and the elevated risk of an oil supply shock.