Monthly Insights October 2021

Second-most abundant liquid on earth after water

Oil has rallied back to its post 2014 high, significantly higher than pre-Covid levels. Both WTI and Brent rose to a year to date high of 84.65 and 86.40 respectively, after touching a multi-years low of 32.60 and 37.13 in April 2020, just when Covid and lockdowns started across the globe. This is an impressive rally of 159.67% and 132.70% for WTI and Brent within 2 years. In fact, most investment banks have raised their oil forecast. The oil and gas industry has emerged successfully from the depths of the coronavirus pandemic to find itself in the midst of an energy crisis. This monthly insight will discuss the factors contributing to the oil rally and its outlook, and lastly the implication on equity market.

According to economic 101, oil price is determined by demand and supply. Sustained demand post Covid and constrained supply imply a tight oil market. On the demand side, global oil consumption has been steadily recovering and is in the cusp of returning to pre-pandemic levels. An energy crisis, in the form of soaring natural gas prices, has contributed to the recent spike in oil demand and therefore, oil prices. In Europe, natural gas prices are up six fold, while in the US and Asia, prices are about 1.5 times higher. In Europe, the price spike in natural gas is equivalent to if oil was trading around USD 200/bbl. Naturally, the result of this gas crisis is demand switching from gas to oil. According to Goldman Sachs research, it was estimated that gas-to-oil switching may be contributing at least 1 mb/d to oil demand, with current gas forwards incentivizing this through winter, and preservation of gas and coal inventories ahead of winter.

Apart from gas-to-oil switching, mobility data continue to point to further oil demands gain in the form of rising jet demand with recent news on travel bans being lifted in the US, Australia, Singapore, Thailand, among others. Monthly jet demand gains have been consistently beating seasonal norms since May 2021, while the usual downward revisions to OAG’s short-term flight schedule forecasts are once again diminishing following the Delta wave. Therefore, seasonality and jet demand recovery should continue to drive demand higher, ensuring stock draws until mid-2022.

On the supply side, two straight years of massive capex cuts are leading to a supply shortage. In a study conducted with Boston Consulting Group, the International Energy Forum calculated that oil and gas companies have slashed their capex budgets by more than one-third in 2020, with another 25% contraction estimated for 2021. According to International Energy Agency’s Net Zero Emission scenario, it was estimated that the oil industry still need to invest USD 365 billion per year to support current demand. However, capex fell to USD 350 billion in 2020, and has not rebounded in 2021, and probably won’t in 2022 either.

To add to the supply constraint, OPEC and its allies agreed to stick to their existing policy of gradual oil output increases despite revising its 2022 demand outlook upwards and ongoing US pressure to raise production more quickly. The reason for this is that OPEC’s market share is looking increasingly strong over the medium term. In the past, OPEC had to make a choice, either to support prices for the short term or defend market share for the long term. These tend to be mutually exclusive, but this is arguably no longer the case. Continued strong oil prices are evidently in OPEC’s interest. At the moment, OPEC can keep the market tight without fearing a non-OPEC supply response. Therefore, it is probable that OPEC will manage the market carefully during 2022, until market share will come its way in 2023 and 2024.

The above mentioned contributing factors point to the fact that the oil market was not only cyclically tight but also structurally undersupplied. Therefore, oil prices in the short term should stay supported. In fact, Morgan Stanley has raised their oil price forecast for 1Q 2022 on Brent and WTO to USD 95/bbl and USD 92.5/bbl respectively. In the short term, there are two key risks to oil prices – China slowdown resulting in lower oil demand due to the property market, and oil demand destruction at current high oil prices. Indeed, with ongoing challenges to the China property market, high-frequency sector activity indicators have been slowing. However, the direct linkages to the energy markets are small. As such, China risks remains manageable and small in the context of an oil market in such a sizable deficit, with no obvious detrimental impact so far to oil consumption.

Another possible risk is if oil prices have reached levels that could bring the market into balance via the demand-side of the equation. With supply constrained across many commodities and inventories fast drawing, several commodity markets have started to price demand destruction as the balancing mechanism of last resort. Based on Goldman Sachs macro modeling, a 10% rise in oil prices would weaken demand only a quarter later. Furthermore, it was estimated that a rise on Brent prices to USD 110/bbl would stifle demand enough to balance the market deficit in 1Q22 given our expectation that OPEC+ continues on the current path of monthly increases in quotas. Therefore, demand destruction would only occur at a much higher oil price.

High oil prices has given rise to inflation concerns, and to the extent of stagflation concerns. Decomposing the drivers of oil, rising demand has consistently been positive for equities. Supply side issues are generally negative, particularly in a tight oil market. Based on UBS modelling, a further 20% rise in oil to USD 100/bbl would provide a 5% headwind for the S&P 500, assuming that it is caused entirely by supply issues. In current scenario, consumption/demand has outpaced supply. The strategy implication of rising oil prices is obvious – Over weight Energy sector. Within the sector, exploration & production (E&P) has been the best performer, up 35% since September. Even on a ROE vs P/B framework, the industry still looks attractive after the run up. Both E&P and Integrated oils have the highest sales growth beta to oil. Integrated and refiners have scope for 9% and 6% upgrades in sales estimates, respectively, when assessing the oil beta implied sales growth. Oil services have lagged other groups and also look attractive, with capex increases key. After Energy, Materials, Banks, and Tech Hardware have outperformed most when oil rises. Defensives, like Pharma, Utilities and much of Consumer, have underperformed the most. In a stagflation scenario, Energy would be the stand out winner, while retailing and consumer services would be most vulnerable.

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