Downside In Oil Looks Limited, Triple Digits May Be Hit Again

Oil Prices Moving Up

sefa ozel

After having an excellent 2021, energy is pretty much the only sector that has positive performance since the beginning of 2022. Now that central banks are raising interest rates in order to fight inflation and China is in yet another lockdown, due to increase in COVID-19 cases, recession fears are kicking-in. As a result, oil prices have retreated quite substantially from their highs. However, looking at demand is only half of the picture and in this article I’ll try to present some supply side reasons, which could weigh in on the upside on oil prices. At the same time, I’ll address some of the fears related to demand, as well as potential upside triggers. Regarding investment action on the bullish thesis for oil, I see The United States Oil ETF (USO) and ProShares Trust II – ProShares Ultra Bloomberg Crude Oil (UCO) as an alternative, short-term way to get oil exposure without the exploration and windfall taxes risk.

The US Strategic Petroleum Reserve dynamics

Following the jump in oil prices after the Russian invasion in Ukraine began, the US government took a decision to start releases from its Strategic Petroleum Reserve (SPR). Since it was established in 1975, there were only three occasions where emergency releases were made – in 1991 as Operation Desert Storm began, a total of 17.3M barrels were brought to market in order to curtail the effects on international oil prices. The second one was in 2005, when the hurricane Katrina disrupted oil production in the Gulf of Mexico, which prompted the government to release 20.8M barrels. The last one was in 2011, when a total of 30.6M barrels were brought to market in order to counterbalance the effects of supply disruptions, mainly from Libya. Given the historical track record, while the current release from the SPR is not unprecedented, its size is. Since the beginning of Mach 2022, more than 185M barrels were drawn as of 11 November. To put that in perspective, this is more than double the combined drawdown of the prior three releases. This has led to 32.1% decline in the stocks of the SPR for the period and has put them at below 400M barrels, which is the lowest level in 38 years.

graph

US SPR stocks and WTI prices [EIA]

Now that the midterms in the US are over, as a pure coincidence, the releases of the SPR are also over. There has been signals from the US administration that it will look into possibly refilling the crude oil stocks at prices in the range in US$67 to US$72 per barrel. I think that such major shift of the dynamic – going from adding almost 1M barrels/day to the supply side to participation on the demand side could be quite significant for oil prices. For that reason, the US$70 mark seems like a floor.

CAPEX still way off record levels

In the 21st century, western politicians have been obsessed with the topic of climate change and fossil fuels have been declared the primary enemy, while coal, oil and gas producers the main villains. The rhetoric against oil and gas have exacerbated in the last decade with some governments like Denmark, moving towards banning exploration and introducing complete production phase-out timing. In such hostile and uncertain environment, it’s not surprising at all, that energy companies have been reluctant to invest heavily into exploration and production, despite the recent cash flow bonanza.

capex

Global CAPEX spending on oil and gas (Evercore ISI)

The President of the United States – Joe Biden has begun his mandate, by slamming fossil fuels. He also disrupted oil and gas exploration activities on federal land and offshore waters. These actions no doubt have been interpreted as a signal by energy companies that their future in the US will be made more difficult, hence their unwillingness for rapid increase in exploration spending. As a testament of this, recent EIA data shows, that in the last two years, more wells were completed than drilled, which will likely limit future production growth potential.

wells

Monthly drilled but uncompleted wells (EIA, Drilling Productivity Report, October 2022)

Even the ongoing energy crisis in Europe appears not to be enough to make politicians shift away from their anti-fossil fuels agenda. Instead of easing the rules and cutting red tape around exploration activities, EU politicians decided to impose windfall taxes on oil and gas companies. UK has done the same. Some developing countries like Colombia, are also following suit and imposing extra levies on oil and gas producers. I won’t be surprised if such policies make companies even more unwilling to spend heavily on expanding production. After all why bear the exploration risk, when few years down the road some politician may decide to force you in “sharing” a big chunk of your profits.

OPEC+ ready to defend the high price environment

OPEC or the wider OPEC+ have already demonstrated its readiness to defend the high pricing environment. In October 2022, the organization decided to act preemptively and respond to potential concerns about recession hitting demand by announcing a 2M barrels/day production cut.

opec

OPECs total production [EIA]

Later on, amidst rumors for potential 0.5M barrels/day production increase, the Energy Minister of Saudi Arabia reaffirmed the previous stance to maintain production cuts until the end of 2023 and has even expressed readiness for further cuts if needed. I see the preemptive actions of OPEC+ as a positive sign regarding maintaining the high price environment. The organization appears united and in control of the situation.

Demand from China will eventually recover

Prior to the COVID-19 pandemic, Chinese oil imports have been on an ever growing trajectory. However, the strict lockdowns introduced by the authorities in order to tackle the spread of the virus have hit energy demand. Now that cases are again on the rise, China is still sticking to its COVID-zero strategy by locking down cities. There have been speculations regarding possible change of strategy and removal of the strict lockdowns. However, no such signals have been given by official authorities. Despite that, it’s quite difficult to imagine that this policy will persist forever.

china oil imports

China’s crude oil imports (CEIC, OPEC)

The overwhelming majority of countries appear to have accepted that the virus have more or less became endemic and the lower mortality allows for the removal of strict restrictions. In addition, a lot of Chinese businesses are suffering from the lockdowns, while the government is trying to stimulate the economy with fiscal measures. So I think it won’t be long before the COVID-zero strategy is abandoned and oil demand subsequently rises.

Price cap on Russian oil?

Following the beginning of the war in Ukraine, Western countries are imposing various sanctions on Russia. However, as the options for new sanctions are running out, the G7 floated the idea of a price cap on Russian oil. And while G7 countries couldn’t prevent others to stop buying Russian oil outside the price cap, they intend to do so indirectly through the insurance services of the oil transportation process. It’s important to mention, that while the exact amount of the price cap is yet to be released, Russian oil – Urals is already trading at a wide discount to Brent since March 2022.

urals

Brent and Urals prices (S&P Global)

With slightly below 10Mboe daily production, Russia is very important for the balance of the crude oil market. In response to the price cap possibility, the Russian government has responded that it will not abide by the limit and work with market-oriented partners or reduce production. So when the price cap is announced, if it’s considerably lower than market prices, this could lead to significant move of oil prices to the upside.

An alternative way to act on the bullish oil thesis

So how could investors who believe in the bullish thesis for oil position themselves? An obvious approach would be to try to pick individual stocks of oil producers, or an ETF comprised of such companies. However, in such a scenario, investors will have to bear exploration risk as well as the risk of windfall taxes.

Chart
Data by YCharts

An alternative way will be to invest in the commodity itself, through an ETF. A popular option is the The United States Oil ETF (USO), which has AUM of US$2.1B and expense ratio of 0.83%. An even more bullish option could be a leveraged ETF like ProShares Trust II – ProShares Ultra Bloomberg Crude Oil (UCO), which aims to double the return of oil. It has AUM of slightly below US$0.8B and expense ratio of 1.10%. That being said, I think that these ETFs are more appropriate for shorter time horizons, as in the long-term stocks of oil producers will likely do better and usually pay dividends.

Risks

Recession risk

This is probably the biggest risk, which could weigh in on demand. However, looking back at the previous recession the decline in consumption was not that great and could potentially be offset by deeper production cuts.

demand

Global oil demand ( N. Sönnichsen; EIA)

In addition any easing of oil prices will likely be used by politicians to double down on their anti-fossil fuels agenda and intensify further the pressure on oil companies, which will likely lead to greater deficits in the future. That being said, if you believe in deep recession, long oil ETFs should probably be avoided. Instead, suppressed oil equities may be a better choice.

Currency risk

Oil is priced in US dollars, so any further US dollar strength will put pressure on oil prices, as developing economies could face difficulties paying for oil. The US itself doesn’t benefit from a strong dollar, as exports suffer, so I don’t think that there’s much further strength in the dollar. On the contrary, as inflation slows down, the US$ may give back some of its gains, which should be supportive of oil prices.

Interest rates risk

High interest rates could lead to economic slowdown, hence lower demand for oil. Given the high indebtedness of the worldwide economy, especially of some European governments, I don’t think high interest rates are here to stay for long. As unemployment creeps up and larger and larger share of GDP has to go towards interest payments on the debt, there will be mounting political pressure on central bankers to lower rates, despite inflation.

Conclusion

Oil prices could be heading higher very soon as there are a few factors that could weigh in on the upside. At the same time, the potential for the US to refill its SPR at around US$70/barrel mark should provide protection to the downside. At the same time, as long as fossil fuels continue to be vilified by politicians, rapid capital investment by energy companies seems unlikely. Getting short-term oil exposure through ETFs like USO or the leveraged UCO could be an alternative option for investors who don’t want to bear exploration risk or the risk of windfall taxes.

Be the first to comment

Leave a Reply

Your email address will not be published.


*