Global equity markets continue to digest a number of issues that have paused the markets’ upward momentum. Supply chain bottlenecks that are plaguing multiple industries, and are exacerbating inflationary pressures which were already creating unease among investors. The third quarter earnings season, which is now underway, will provide data reflecting how well companies are navigating through the challenges. Below, we discuss the energy industry, and oil in particular, which is experiencing a resurgence driven by its own supply issues.

 

Crude oil prices have more than doubled over the past year, rising from below $40 per barrel to more than $80. The anticipated recovery in demand has unfolded, as the world’s economies have been reopening to varying degrees and levels of mobility and activity are returning to normal. In addition, some countries in the northern hemisphere are expected to switch from natural gas to oil to fuel their power needs, as natural gas prices in Europe have spiked and are higher than oil on a per-barrel-equivalent basis. This shift adds another tailwind to oil demand.

 

A stronger demand backdrop is partly responsible for some of the oil price gains, but the bigger driver has been supply. There has been notable under-investment in oil exploration and extraction over the past decade. Oil may be following the typical path of a commodity cycle: high prices encourage growth in exploration, development, and production, which eventually leads to oversupply, weaker prices, and cutbacks to capital expenditures. Then, years later, the underinvestment leads to a lack of supply, which eventually drives prices higher. This classic cycle may indeed be playing itself out again.

 

There are some attributes that make every commodity cycle unique. For the current oil cycle, the most noteworthy factor has been the focus on climate and sustainability in the public and private sectors, which has made access to capital more difficult in the fossil fuel industry. Short-term improvements to the access to capital may be limited, given political pressure and the long-term nature of the commitments that entities are required to make. This hurdle, along with climate-related demands from various stakeholders, has forced many North American oil producers to focus on efficient capital allocation and the prioritization of shareholder friendly initiatives over recent years, as opposed to their previous strategy of maximizing oil production. While the U.S. oil industry was regarded over the past decade as being the world’s swing producer – able to turn its oil taps on and off relatively easily –it may be less reactive going forward.

 

There has been a similar shift among the thirteen members of the OPEC cartel, including Saudi Arabia. The cartel has been cooperating with Russia, and appears to be prioritizing oil price stability and strength with only marginal increases in supply. This approach has helped many cartel members improve their fiscal situations compared to the deficits created by their previous strategy of maximizing global market share at any price. It is difficult to predict whether this level of restraint will persist for the foreseeable future. We have witnessed many unexpected twists and turns in the past with respect to OPEC and Russia, who collectively control more than half of the world’s oil production. Supply levels are likely to remain a source of uncertainty that investors will have to account for in the management of portfolios.

 

The prevailing oil prices will inevitably lure more supply into the market as is typical in an upcycle. Nevertheless, the rate of supply growth may fall short of prior cycles given some of the climate change related constraints mentioned above. The supply and demand dynamics have the potential to remain supportive of prices that are more elevated than we have been accustomed to over the past decade. We believe the global economy has the capacity to handle higher oil prices, to a certain extent, given the elevated savings of consumers and the further economic reopening that still lies ahead.

 

The oil sector will benefit from a more robust oil price backdrop. Some of this is likely already reflected given how well the energy sector earnings, cash flow and share prices have performed year-to-date. Despite this, the sector is not widely owned by global investors because of the previously weak prices and meager investment returns from the past decade. In addition, some investors have incorporated an ESG framework– environmental, social, and governance – into their investment decision making process. This has led some to minimize, if not entirely eliminate, their allocations to the fossil fuel industry. We suspect that some investors will return to the sector as they try to capitalize on the improving environment, and this could help support existing stock prices. Other investors may remain steadfast in their approach to sustainability and resist the temptation to revisit the sector. Overall, we expect that there will be stronger demand for energy stocks relative to the past few years, but not to the extent we have seen in past cycles.

 

The evolution to a more sustainable future that involves more sources of renewable energy is very much underway, but will take decades to unfold. In the meantime, the world’s economy still depends on oil, and the lack of supply combined with recovering demand suggests that an upcycle is already be underway. The oil industry should continue to see some better days ahead, even if the longer-term challenges posed by the global energy transition remain in place.

 

Should you have any questions, please feel free to contact us.

Drew M. Pallett LL.B. CFP www.pallett.ca