Time for some crude calculations

Equity markets are buoyant, fixed income markets seem more nervous – judging by how yields are rising (at least for government issue in the developed West) – and commodity prices continue to march to their own beat, as gold and silver surge, industrial metals largely flatline, and oil and gas remain subdued.

“The (relative) calm that pervades hydrocarbon prices is in many ways surprising, given the ongoing war in Ukraine, Russia’s role as a top-three supplier worldwide, and heightened tensions in the Middle East.”

The (relative) calm that pervades hydrocarbon prices is in many ways surprising, given the ongoing war in Ukraine, Russia’s role as a top-three supplier worldwide, and heightened tensions in the Middle East.

Oil and gas prices trade a long way from recent peaks

Source: LSEG Refinitiv data

There are clearly far more important, humanitarian issues at stake in both conflicts, but, from the narrow perspective of financial markets, investors must pay attention too, especially because of oil and gas. Equity markets’ preferred scenario of cooling inflation, a soft landing for Western economies and lower interest rates from central bank is playing out to perfection, with the result that indices such as the S&P 500 and NASDAQ Composite in the US, DAX and MIB-30 in Europe, and even the benighted FTSE 100 trade at or very close to multi-year or even all-time highs.

Weakness in energy prices is a key part of this, as it is feeding into lower inflation. Any resurgence in hydrocarbon prices could therefore lead to an upset, and it should be worth assessing the key sensitivities here as part of any risk management process.

Energy components of consumer price indices are helping to cool headline inflation rates

Source: LSEG Refinitiv data

Bear case

“Near-term sentiment toward oil and gas prices remains broadly negative for three reasons.”

Near-term sentiment toward oil and gas prices remains broadly negative for three reasons.

• The International Energy Agency (IEA) continues to assert that demand growth remains anaemic, thanks to China in particular. It argues demand will increase by less than one million barrels per day, on average, in 2024, a marked slowdown from the two-million-plus pace seen post-pandemic in 2022 and 2023. OPEC has also just cut its demand growth forecasts for this year and next, although it is more optimistic than the IEA with forecasts of 1.4 million barrels a day for 2024 and 1.6 million for 2025.
• The IEA also argues that supply is plentiful, even allowing for tensions in the Middle East and output disruptions in Libya, thanks to the febrile political situation there. OPEC+ continues to restrain capacity too, so there is scope for increased supply here. Meanwhile, American output continues to surge and stands near record highs of 13.2 million barrels a day, thanks to shale, to mean that OPEC+ is not the only game in town.
• Israel has promised not to target Iranian oil facilities in any attacks. The Kharg Island terminal there is particularly important, as it ships 1.6 million barrels of oil a day, or just under 1.5% of total global demand.

Overlaying of all of this remains the long-term issue of the global transition toward more renewable sources of energy and away from hydrocarbons which should, in theory, dampen demand for oil in particular.

Bull case

“Central bankers, politicians and consumers will doubtless all be hoping the IEA’s prognosis about oil demand and supply proves correct and energy prices remain contained, as may environmental campaigners.”

Central bankers, politicians and consumers will doubtless all be hoping the IEA’s prognosis about oil demand and supply proves correct and energy prices remain contained, as may environmental campaigners. Only oil company executives and shareholders may be less pleased, and in the case of the latter they will note the S&P Global 1200 Energy sector is back down to just 3.8% of total S&P Global 1200’s market capitalisation. Indeed, the S&P Global 1200 Energy sector’s entire market cap of $2.7 trillion is less than that of Apple, NVIDIA or Microsoft.

Energy and oil stocks are out of favour once more

Source: LSEG Refinitiv data

“However, it could be unwise to write off oil just yet, also for three reasons.”

However, it could be unwise to write off oil just yet, also for three reasons.

• Demand continues to grow. Even if the IEA and OPEC expect less growth than before, the globe continues to rely heavily on hydrocarbons.
• Even though we continue to consume more oil and gas, drilling activity remains subdued, thanks to the pricing environment, and the combination of political and public pressure. If demand does stay more robust for longer than expected, then supply may not be as adequate as we would like to hope.

Global drilling activity remains depressed

Source: Baker Hughes, LSEG Refinitiv data

• The US Strategic Petroleum Reserve (SPR) is still diminished, at 385 million barrels, way below its 714-million-barrel capacity, after the Biden administration’s liquidation of assets to try and cap fuel and gasoline prices for US consumers. At some stage it would make sense to top this back up, especially at a time when energy supply could be a matter of national security.

“The OVX index, which measures anticipated oil market volatility, just as the VIX index does for stock markets, trades at 47, well above its historic average of 37. That suggests oil traders remain on a state of high alert, even if equity prices are not putting much, if anything, of a geopolitical premium on hydrocarbon prices.”

The OVX index, which measures anticipated oil market volatility, just as the VIX index does for stock markets, trades at 47, well above its historic average of 37. That suggests oil traders remain on a state of high alert, even if equity prices are not putting much, if anything, of a geopolitical premium on hydrocarbon prices.

OVX index stands above historic averages

Source: CBOE, LSEG Refinitiv data

It is to be hoped that such complacency does not lead to shocks further down the road.

Past performance is not a guide to future performance and some investments need to be held for the long term.