By Dan Zolet, CFA
SUMMARY
- OPEC+’s goal is sustaining elevated oil prices.
- US government likely to purchase oil for reserves, boosting demand, in our view.
- We believe US Energy equities are well positioned to take advantage of current prices.
Over the past month, we have seen increased volatility in the global oil markets, with Brent crude oil prices breaking $93/barrel in mid-October before falling back below $85/barrel to start November. We have previously discussed some of the structural US supply characteristics and geopolitics that have contributed to this volatility (See Weekly View from 10/24/23). However, until today we have spent less time on some of the tactical supply and demand factors that we believe drive global oil markets, as well as the energy stocks and bonds we own in our portfolios.
Supply: OPEC+ Needs Higher Prices; US More Efficient, Less Excess Capacity
When focusing on the supply side of the oil markets, there are two major players to focus on, OPEC+[1] and US producers. Combining the US and OPEC+ production accounts for over 70% of the world’s oil supply, but it is their different goals that make them an interesting case study.
This difference creates two very different production decisions. Saudi Arabia has committed to continued output cuts through the end of the year. While this may seem incongruent with already elevated oil prices, a supply cut seems very logical when considering OPEC members’ higher breakeven threshold. Because of this we believe that Saudi Arabia and their fellow OPEC+ members will continue similar supply cuts over the next 12 months.
Source: U.S. Energy Information Administration, RiverFront. Data monthly through July 31, 2023. Chart shown for illustrative purposes.
On the US side of production, looking at Chart 1, we can see that US oil production has just eclipsed its early 2020 peak (on a trailing 12-month basis) and producers are likely operating close to full capacity. Additionally, US government regulations provide some natural buffer against other entrants, which gives existing US companies a natural “moat” where they have a cost structure advantage and barriers to competitors entering the market. This only strengthens OPEC+’s ability to influence prices, who could constrain supply over the next 12 months.
[1] Current OPEC members: Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC+ includes nonmembers Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan.
Demand: Waiting on the Strategic Petroleum Reserve
When discussing global oil demand, one driver is the US Strategic Petroleum Reserve (SPR). The SPR acts as the US’s emergency oil supply and is used to lessen oil market disruptions in the US, a role it filled last year during the Ukraine conflict. Looking at Chart 2 (right), we can see this drawdown in the SPR since 2021, which has yet to be replenished. We believe this will eventually reverse, as the US will reload at some point to guard against future market disruptions, providing support for our view that oil can stay elevated. With recent increased geopolitical tensions, the need for replenishing the SPR becomes more urgent. This demand should help buffer oil prices against some slowing in the global economy coming from China and elsewhere, in our view.
Source: U.S. Energy Information Administration, RiverFront. Data monthly through October 6, 2023. Chart shown for illustrative purposes.
US Energy and P.A.T.T.Y. – We Remain Bullish on the Energy Sector
Given our view of constrained supply and sustainable demand, we favor the Energy sector and believe that the price of oil will remain elevated over the next 12 months. We also believe the cost discipline and heightened regulatory environment create a wide ‘moat’ for US Energy companies relative to international competitors, which helps explain why we favor these types of companies in our portfolios.
The energy sector plays particularly well into the ‘P.A.T.T.Y.’ (‘Pay Attention to the Yield’) theme that we outlined in our 2023 Outlook. As we mentioned earlier, US energy companies have breakeven prices well below the current price of oil, which translates to positive free cash flows for these companies. These free cash flows can be returned to shareholders through both dividends and share buybacks. In addition, well-capitalized energy companies should be able acquire the assets of firms that have compelling prospects but are challenged by the rise in interest rates.
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Definitions:
Oil benchmarks describe where the commodity originates, which determines its use and allows investors to track the price of a specific oil type. Brent Crude is the benchmark used for the light oil market in Europe, Africa, and the Middle East, originating from oil fields in the North Sea between the Shetland Islands and Norway.
The term Organization of the Petroleum Exporting Countries (OPEC) refers to a group of 13 of the world’s major oil-exporting nations. OPEC was founded in 1960 to coordinate the petroleum policies of its members and to provide member states with technical and economic aid. OPEC is a cartel that aims to manage the supply of oil in an effort to set the price of oil on the world market, in order to avoid fluctuations that might affect the economies of both producing and purchasing countries.
Strategic petroleum reserves (SPRs) are stockpiles of crude oil maintained by countries for release in the event of a supply disruption. The U.S. Strategic Petroleum Reserve (SPR) is the world’s largest with an authorized maximum capacity of 727 million barrels. The U.S. government has historically tapped into its SPR following manmade accidents, economic crises, and natural disasters, though it has also sold and loaned crude oil from the SPR to other nations at times.
The Energy Information Administration (EIA) is a government agency formed in 1977. The EIA is responsible for objectively collecting energy data, conducting analysis and making forecasts. The EIA’s reports contain information regarding energy-related topics such as future energy inventories, demand, and prices. Its data, analysis, and reports are available online to both the public and the private sector.
The energy sector is a category of stocks that relate to producing or supplying energy. The energy sector or industry includes companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, and refining. The energy industry also includes integrated power utility companies such as renewable energy and coal.
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