What Rising Oil Prices Mean for Energy Investors

Market Updates

What Rising Oil Prices Mean for Energy Investors

Pavel Molchanov, Energy Analyst, Equity Research, examines rising oil prices and their effect on energy industry stakeholders.

July 2, 2018

Oil prices rallied throughout the spring, reaching the highest levels since 2014. What’s driving prices?

Basic economics holds that when demand exceeds supply, prices should rise. Well, that is precisely what has been hap­pening in the global oil market – and for much longer than the past few months. The trough of the down cycle for oil prices occurred back in February 2016. The key fundamental metric we focus on is global petroleum inventories (not solely U.S.), which declined by an average of one million barrels per day in 2017. We are forecasting a similar decrease in 2018, with inventory levels falling below historical norms.

By definition, these inventory drawdowns mean that demand is running ahead of supply. For the fourth consecutive year, global demand is set to grow faster than its long-term average of 1.4% per year, with emerging markets continuing to drive (quite literally) the bulk of the increase. Supply is also up, but is limited by several factors. Larger U.S. oil pro­ducers are exhibiting restraint in capital allocation, meaning they are spending less on business investment, marking a shift from their historical tendency to overinvest. Addition­ally, OPEC’s production discipline, led by Saudi Arabia, remains intact, and there are still supply declines in several non-OPEC geographies such as Mexico. Finally, supply dis­ruptions/challenges, especially in Venezuela, continue to weigh on inventory levels.

That being said, it is worth underscoring that the oil futures curve is currently downward sloping (also referred to as ‘backwardation’), suggesting that the commodity market is signaling a sharp drop in oil prices from current levels over the next three years. On the contrary, our view is that prices still have room to move higher over the next several years.

Who wins and who loses from the higher oil prices?

As one would expect, energy investors are among the clear winners. After having underperformed the S&P 500 in six of the previous seven years (all except 2016), the energy sector is outperforming year-to-date. There have been outsized gains in higher-beta stocks with above-average leverage to oil prices, while defensive/conservative energy stocks and those with a focus on natural gas have generally lagged. More broadly, the current oil price landscape is helping to revive investment and job creation in geographies that felt the pain of the down cycle – Russia, Texas, and Alberta – not to mention many of the OPEC countries.

In general, higher oil prices are not ideal for the world’s major economies since most of them are net oil importers. This is especially true for Japan, India, and most of Europe. The U.S. and China present more of a mixed picture, since they produce a sizable portion of their oil consumption. In oil importing countries, the average consumer will have to pay more for their fuel this summer than at any point since 2014. Average U.S. retail gasoline prices are already approaching $3.00/gallon, as compared to less than $2.50/ gallon one year ago. This could result in a revival in sales of smaller cars, which have generally been sidelined in recent years as consumers gravitated to trucks and SUVs.

What role is Iran playing in the oil price rally?

The short answer is not much. The White House’s deci­sion in May to reinstate a range of economic sanctions against Iran is contributing to the geopolitical risk pre­mium in the oil market, but this is mostly a matter of ‘headline risk’ and sentiment. The decision to impose sanctions, in and of itself, does not curtail Iranian oil supply. For such curtailment to materialize, one of two things would need to happen. First, a significant number of European and Asian countries would have to revive their own import restrictions, returning to the 2012-2015 policies in place prior to the signing of the nuclear deal. Given how much Europe wants to salvage the nuclear deal, that’s not likely, provided Iran does not escalate the situation.

The second scenario would be a full-scale war with tankers physically blockaded – also not likely without major escalation. From a long-term perspective, the wild card will be the willingness of international energy compa­nies to invest in Iran (bearing in mind that U.S.-based players have no operations there). The threat of U.S. sec­ondary sanctions will create an additional barrier, but the fact of the matter is that such investments have been min­imal anyway.

Read the full July 2018 Investment Strategy Quarterly
Read the full July 2018 Investment Strategy Quarterly

All expressions of opinion reflect the judgment of Raymond James & Associates, Inc., and are subject to change. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risk including the possible loss of capital. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. Commodities are generally considered speculative because of the significant potential for investment loss. The S&P 500 is an unmanaged index of 500 widely held stocks. It is not possible to invest directly in an index Past performance may not be indicative of future results.

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