One of the few bright spots for both the S&P500 and TSX has been the energy sector which has returned over 25% YTD in 2022. This return looks even more impressive considering these indexes have fallen by 25% in just the last month, driven by fears of recession. Many investors have asked us whether the most recent volatility shakes our conviction in oil and oil stocks as investable assets. Below we aim to provide support to what we see as strong fundamentals for the oil sector.
No Signs of Demand Destruction
Fears of a recession are associated with reduced energy usage and economic activity. However, financial markets show no signs of reduced demand. This can be evidenced by oil ‘Time Spreads’, which track the premium on oil over specific time frames. In periods of expected weak demand, the time spread should decline as investors are not willing to pay a higher premium for oil. However, currently, we see that Time Spreads are still elevated and rising, signifying that demand is still robust. We also see that global inventories are continually being drawn down with the deficit in oil worsening relative to pre-COVID levels. This resilience in consumption can be partly attributed to persistent pent-up demand and a strong labour market that boasts a record low unemployment rate of 3.6%. A tight labor market should limit the amount of demand destruction that typically occurs during a recession. Hence, in the face of a potentially slowing economy, the overall consumer could buckle but they should not break. Therefore, U.S. gasoline consumption is expected to be robust. Research from the industry-leading firm, Energy Aspects, have noted that weaker GDP could cause a 2% decrease in gasoline consumption, however, this would be offset by a 4.2% increase in demand due to the strong employment trends. So, as it pertains to oil and gasoline consumption, employment appears to be the more impactful driver.
Oil Demand In Times of Recession
Historically, oil demand has continued to rise even during periods of recession. Only in extreme periods have we seen demand fall, such as during the Arab Oil Embargo, the Great Financial Crisis, and COVID-19. In other recessionary periods, including the ’97 Asian Crisis, the Tech Bubble, and the economic malaise of 2011 and 2014, oil was still able to grow every single year by approximately 1 million barrels per day. History has shown that the demand for oil is, in fact, quite inelastic. No example is clearer of this than in April 2020. In the midst of COVID, when 97% of global industrial production shut down and global economies literally closed, oil demand only fell by 20% (18-20 million barrels per day). Even with everyone sheltered at home, the amount of oil that is consumed is tremendous.
Amrita Sen, Founder and Director of Energy Aspects, holds one of the more conservative forecasts of global energy demand for next year. While many of her peers expect global energy demand to rise by 2 million barrels per day in 2023, Amrita Sen has run a recessionary model, with oil demand increasing by ‘only’ 900,000 barrels per day. Under this “ultra-conservative” demand scenario, global oil inventories are still being drawn down and depleted. Essentially, the lack of supply growth overshadows the decline in demand; hence, inventories continue to decline. This imbalance should keep oil prices fundamentally higher. Amrita’s recessionary oil model includes a drop in demand from Europe by 400,000 barrels per day and decreased U.S. demand by 100,000 barrels. These decreases are offset by the immense demand recovery witnessed across Asia including, Indonesia, Thailand, South Korea, and Japan. Of course, should China fully re-open its economy, this demand should further intensify.
Structural Supply Problems
The cornerstone of the most ‘bullish’ forecasts in oil lies in the lack of supply and production. The ‘Super Major’ oil producers have resisted increasing production as their shareholders insist they focus on paying down debt, share buybacks, and dividends. Currently, there is roughly $400 billion planned in ‘upstream capex’; however, estimates require about $520 billion in capex just to keep global production flat at 100 million barrels per day. With demand already above 105 million barrels, the world is already coming up short. Moreover, adding rigs and wells is not easy as CEOs have cited a shortage of labour, as well as long wait times for steel that can extend from 10 to 180 days. As a result, companies like Saudi Aramco, the world’s largest oil producer, have announced plans to add 1 million barrels per day of production capacity, however, even this will take 5 years to build out!
This supply conundrum is further intensified with OPEC+ expected to run out of spare capacity. Just last month, the Secretary General of OPEC, Mohammed Barkindo, spoke at an RBC Energy Conference confirming that OPEC+ was imminently running out of capacity. Some analysts estimate that this will occur before the end of this year. Traditionally, a healthy spare capacity figure would be around 5% of global oil demand, however, current estimates are for less than 1% by year-end. This leaves supply in a very fragile state as the scales can be easily tipped by sudden outages caused by inclement weather or if even a small country like Libya goes offline.
One doesn’t have to look long-term for potential upside catalysts for oil prices. In the fall, Biden’s release of up to 260 million barrels of oil from the U.S. Strategic Petroleum Reserve (SPR) will end by October. With less oil being supplied, this could put further upwards pressure on oil prices. Moreover, in November, China will be holding their 20th National Party Congress, where it is expected Xi Jinping will update the nation on their Zero-COVID Policy. With mounting pressure to ease COVID restrictions, a further re-opening of the Chinese economy will reduce production bottlenecks and spur the type of economic growth that typically results in greater oil demand. Finally, the European Union’s embargo on crude oil against Russia will begin in December, and their ban on Russian petroleum products begins next February. This commodity landscape could be further shaken should Russia retaliate by shutting down core regional infrastructure like the Nord Stream Pipelines that supply significant natural gas to Europe. Overall, the uncertainty that plagues the oil & gas industry could lead to higher oil prices.
Currently, we believe that oil stocks will be held hostage by the narrative of recession and the falling price of oil. Given that these investments have highly outperformed over the last 12 months, it would not surprise us to see this sector being treated as a source of funds to sell during periods of volatility. However, in the intermediate and long term, the structural undersupply of oil should provide support for elevated oil prices. The analysts and equity managers we work with suspect that oil should stay in the range of $100 per barrel for years to come, which would yield immense free cash flow to oil producers. We recommend investors speak to their advisor and review what metrics to consider when investing in oil stocks domestically and abroad.