What’s Next For Oil’s Price?

What’s Next For Oil’s Price?
Andrew Rummer

almost 3 years ago10 mins

Mentioned in story

One of the major themes for investors at the moment is the potential for inflation to take off. We’ve seen a ramp up in stimulus from governments and central banks to support their economies through the coronavirus pandemic, and some believe this will ultimately lead to inflation. And one of the classic places to shield your investments from the corrosive effects of inflation is in commodities. After all, a bar of gold or a barrel of oil remain just as they are irrespective of what’s happening in the bond or stock markets. 

So, with that in mind, we wanted to bring in a professional who spends all day studying oil markets to help us understand where the price of oil and the shares of energy companies might go from here. Our analyst Andrew Rummer sat down with‎ Martin Rats, global oil strategist and head of European oil & gas equity research at Morgan Stanley

He began by talking through the big-picture drivers behind some of the huge swings in the price of oil we’ve seen in recent years, from concerns about inflation to production cuts from OPEC, the Saudi Arabian-led cartel of oil producing nations. 

Martijn Rats: The price of oil depends on two things: it depends on the value of oil and it depends on the value of money. And there is a story to be told about both of these things. And just to start off with the value of oil – that is a relatively straightforward analysis of supply and demand. And what happened last year, of course, is that much of the world went into lockdown. People stopped driving, people stopped flying – demand collapsed precipitously. And it took a while for supply to catch up. So we were faced with this period of very strong oversupply for a while and prices naturally fell. What we're currently seeing is broadly the opposite. The supply side has caught up. We've seen sharp declines in US production, OPEC has taken off a lot of barrels from the market. And now demand is slowly but surely starting to recover. And you have the mirror image of last year: supply struggles to keep up with demand. And so, at the moment, the oil market is under-supplied, and that means the value of oil is higher, the market is tighter. But on top of that there is also a story to be told about the value of money. There are, at the moment, about a quarter more dollars in circulation than this time last year. We've seen an enormous amount of stimulus from a broad range of governments around the world. And when governments stimulate the economy by extra spending, they do so from borrowed money. But an extra dollar borrowed is an extra dollar created. So the money supply has risen. And with that have come concerns about inflation – about the total amount of goods and services that you can buy for a dollar. And with rising inflation concerns, people tend to – at the margin – have an incremental preference for keeping their money in commodities – like oil – and less in cash. And so there is also a story to be told about the value of money: all of commodities as a result of these rising inflation expectations have gotten a boost – and oil has participated in that. 

Andrew Rummer: There does seem to be some tension between those analysts who are generally very optimistic about commodities prices at the moment – including oil – because of that inflation story you were talking about. And then on the other side, we had the International Energy Agency earlier this month coming out and saying that the world is basically awash with oil, so don't get too excited about the price rising that much further from here. So where do you come down on either side of that debate?

Martijn: There is a real debate in the market between the bulls and the bears on either side. To say that the world is awash with oil, it's sort of technically correct, in the sense that inventories of oil are high – we have a lot of oil in storage. And in principle, there is a lot of spare capacity to produce. Both of these things are correct. The alternative way of interpreting nearly the same data is to say, well, inventories might be high, but they're falling very fast, which shows you how undersupplied this is. Surely inventories are high now but they will be very low by the end of the year. And yeah, spare capacity is high, but we need that spare capacity for when we'll start flying and driving again. And that spare capacity will not exist for very long either by the end of the year, that too will have largely gone. Now I think those latter interpretations are indeed correct. And we could well be in a situation where by the end of the year, when a large part of the world is vaccinated for the Coronavirus that we will return to greater levels of mobility, there will be more transport there'll be more aviation demands will likely to be substantially higher, that this whole this this sort of awash in oil story will look very different.

If you project from there forward, there is quite a sort of fundamental debate in the oil market, about what then really comes first. Sure, we have a cyclical recovery but then what does it look like structurally? Oil demand will likely peak at some point in the future, but supply will also likely peak. And over the last couple of years, we've seen tremendous pressure in the oil industry. On the levels of investment, the oil industry has invested less and less and less nearly every year between 2014 and 2020. The investment levels in the oil industry are down by about 60-65% or so. So, sure, as electric vehicles come in, the demand for oil will likely peak at some point – but maybe the supply for oil could also peak. The oil market is simply interested in the balance between the two. And, at this stage, it is not quite clear which of the two will peak earlier. If demand peaks earlier, we could be structurally oversupplied for a long time to come. If supply, on the other hand, peaks earlier – because we've invested so little – then, surprisingly, as the energy transition unfolds, it is also possible that we have several years of great tightness. Now that debate is largely unresolved. And it is simply very hard to know. And my suspicion is that oil prices will remain manageable, that we're not going into a supercycle squeeze. But there are credible people and good arguments also on the other side of the debate.

Andrew: Turning from oil as a commodity and thinking about shares of oil companies themselves, how is the industry going to deal with the challenge of climate change and the transition away from fossil fuels? And what does that mean for investors considering buying shares in oil companies? 

Martijn: The answer is probably that there isn't a homogenous answer for the industry at large. In the past, it was often quite difficult to distinguish one oil company from the other – they were all doing the same thing. At the moment, we are seeing very divergent strategies from oil companies around the world. And that means that some will turn out to make the right choice, and some will turn out to make the wrong choice. And we will have to see in sort of five to 10 years from now, some companies will have flourished and some others will no longer exist, I think that is that is increasingly likely much more so than it's been over the last 10 years. If you are a pure-play exploration and production company – and your business model is find oil, produce it, sell it – then, look, there is only so much you can do. And perhaps 15-20 years from now, those companies will no longer exist. But if you talk about what in the public's eye are often the oil companies – the supermajor oil companies, the big oil companies where we all go to to fill up our tank of our car, those companies – the Shells, the BPs, the Totals of this world – they have a lot to work with. They have enormous customer bases, they have global reach, they have tremendous experience in developing large infrastructure projects. They have strong relationships with governments around the world. And those are precisely the skills and the capabilities that you would need to build out the renewable electricity infrastructure of the world. And they are increasingly doing so. Now even within those companies there are different strategies and bets on different technologies. But it rounds off several of these very large companies, they literally have hundreds of millions of customers, and every year, and those customers still need energy. So it's a matter of them trying to figure out, “Who are my customers? What energy do I need? And how can I supply that customer with green decarbonized energy in the future?” 

Andrew: When I talk to Finimizers out there, plenty of them have no desire at all to invest in anything related to the oil industry. What would you say to those who are reluctant to get involved in the industry for environmental reasons?

Martijn: I hear that a lot. It is an argument that comes up for very small investors, but even very large investors – big pension funds around the world – are struggling with the same issues. So it's across the investment community this sentiment exists, and it's an understandable one: oil has a big carbon footprint and that doesn't fit well with climate change. Now, it's something that, at some level, it is simply a personal choice that people need to make. There is a scenario where the energy transition goes slow and we really struggle to address the issues around climate change, and perhaps, then oil companies will continue to make more money from producing oil. And there is an argument to be said, be that as it may, I simply do not want to be in a position where I benefit from that. That is a personal choice that people need to make. At the same time, it is also true that whether people buy the shares or not makes very little impact on the actual underlying issue, which is carbon emissions and climate change. Oil companies do not rely on issuing new shares to fund themselves like a lot of growth companies do – they often rely on equity issuances, issuing more shares to get money in to finance their investment programmes. The oil industry is a mature industry, it is not growing very fast. And oil companies finance themselves from their own internally generated cash flows. And so, in that sense, they will continue to do so. And whether somebody owns them or not, doesn't change that all that much. If you don't own them, the shares exist and they don't go away. It simply means somebody else owns them. So in that sense, it has little impact. 

Going through the energy transition will, in the end, require enormous investments – hundreds of billions. The world is not going to do that with startups. The world is going to do that by getting the big energy companies on board – the big oil companies, big utility companies. In the end, the practical reality is that it's those type of companies that will need to make those investments. And particularly, if you look at European oil companies, they are the ones that are going to make these investments. The oil industry, as you know, it is changing dramatically. And the entire European oil sector is embracing this agenda, and is gearing up for investments in wind, in solar, in hydrogen, electric vehicle charging stations, these companies will look fundamentally different 10 years from now. So in the end, it's a personal choice. But at the same time, I would say that if we roll the clock forward by two, three, four, or five years, we could be having a fundamentally different conversation where these companies could be seen to be the drivers of the energy transition, and solving climate change.

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