The article below is an excerpt from our Q4 2022 commentary.
We believe investors are being far too complacent about oil markets.
After making a 14-year high of $130 per barrel in March, prices have steadily pulled back to $80. Concerns around the security of supply following Russia’s invasion of Ukraine have given way to worries about recession and sagging demand. Oil has nearly given back its entire move higher since the attack took place on February 24th, 2022.
Demand fears are misplaced; we believe supply issues will drive the oil market for the foreseeable future. Crude demand has proved far more resilient than most analysts have expected for nearly two decades. For example, economic activity slowed following the 1980 oil price spike, and demand fell almost 10%. It took nearly ten years for demand to surpass the 1980 peak.
On the other hand, economic activity plummeted following the 2008 price spike and the global financial crisis. Instead of falling by 10% (or even more), crude demand fell by only 1.5%, surpassing the 2007 peak in 2010. The difference was that in 1980, OECD countries made up 68% of global oil demand, whereas by 2010 it was only half. Emerging markets have a much different price elasticity and demand profile than developed countries: consumption is far more resilient. More recently, during COVID, energy analysts argued vociferously that global demand would never again regain 2019 levels. Less than three years later, the International Energy Agency (IEA) expects 2023 demand will be 1.4 m b/d greater than in 2019. In our view, the old energy demand models, centered on developed country trends, no longer apply.
On the other hand, investment drives supply, which remains extremely low. Between 2014 and 2019, global upstream E&P spending fell by one-third from $900 bn to $600 bn. COVID slashed budgets further, and they have not recovered. The IEA estimates that by 2022, spending was down by another 30% compared with 2019 to only slightly more than $400 bn. We believe this is not enough. We have starved this industry for capital for eight consecutive years and are feeling the effects. We believe the energy crisis will only improve once the sector increases spending. Based on recent announcements, no material increase in spending is in sight.
This past year marked the second consecutive year of oil inventory draws. Since December 2020, global stockpiles have collapsed by 600 mm bbl – eclipsing the previous record set in 1999/2000 by 2.5 times. All indications point to an unprecedented third year of inventory draws in 2023. Stockpiles stand at four bn bbl – a level last seen in 2003. If our models are correct, inventories could end the year at 3.2 bn bbl, the lowest reading since 1986.
Somehow, after nearly three years of oil market tightness and two years of strong equity performance, investors still refuse to allocate capital to the space. Over the last two years, energy has outperformed any other sector in the S&P 500 by 130 percentage points and the index by 150 percentage points. And yet, energy still represents less than 5% of the S&P500’s market capitalization – less than half its long-term average and 65% below the 2008 peak.
Has the two-year rally finally started to convince investors?
Quite the opposite: since mid-2021, investors withdrew billions from the largest energy-equity-related ETFs -- the XOP and XLE. Over that period, the XLE (which tracks large energy companies) generated a total return of 72% while the XOP (which tracks independent E&Ps) advanced 45%, compared with the S&P 500 as a whole, which fell 1.6%. Despite the strong outperformance, the XLE saw $1.3 bn in net outflows over the period, while the XOP saw $1.8 bn in net outflows. Over $1 bn of the combined net outflows occurred this year alone. Last year, we estimated energy companies generated 35% of the entire cash flow of the S&P 500 despite being less than 5% of the index’s market capitalization; the relentless liquidation continues. Is it possible that energy executives are not keen to grow their assets when investor sentiment remains bearish?
Investor interest aside, oil market fundamentals remain extremely strong. Although demand was weaker than expected in Q4, our models suggest warm weather was a key factor. Following Russia’s invasion of Ukraine, European policymakers dramatically switched from natural gas to help replenish stockpiles ahead of the winter. While coal and biomass were the primary beneficiaries, oil demand increased. As gas inventories grew and the winter proved warmer than expected, this crude demand fell. Some crude demand destruction likely took place, notably for gasoline and diesel. When West Texas Intermediate crude prices reached $122 per barrel in June, refined product prices exceeded $170 per barrel as refining bottlenecks caused crack spreads to expand dramatically.
Despite weaker-than-expected second-half demand, we estimate that global oil markets were in structural deficit by as much as 500,000 b/d throughout 2022. Furthermore, our models tell us this deficit will worsen as we progress through 2023. In their latest Oil Market Report, the IEA implies that oil markets will be in deficit by as much as 600,000 b/d this year. It is infrequent for the IEA to predict a deficit; typically, their estimates skew toward a surplus. We cannot recall any other time, under normal market conditions, when the IEA predicted a large deficit.
Our models tell us the deficit could be even more extreme. The IEA estimates that demand will grow by 1.9 m b/d, reaching 101.9 in 2023. However, several adjustments are necessary. First, the IEA has “missing barrels” in its balance sheet. As long-time readers recall, “missing barrels” occur when, according to the IEA, companies produce oil that is neither consumed nor added to storage. The result is a “miscellaneous to balance” line item on their balance sheet that we refer to as the “missing barrels.” In reality, this oil is not missing but almost always signals forthcoming upwards revisions to demand. In 2022, the “missing barrels” ran at 300,000 b/d, including a massive 700,000 b/d figure in Q4. Assuming that the “missing barrels” are underreported demand, 2023 consumption could reach 102.2 m b/d. Chinese demand could also be higher than expected.
The IEA predicts their consumption will grow by 900,000 b/d to reach 15.9 m b/d. Although this sounds like impressive growth, they are likely understating demand given how dramatically COVID-zero policies impacted 2022 figures. We estimate last year’s lockdowns moved demand by 1.5 m b/d for at least seven months. Over the entire year, this lowered demand by 850,000 b/d, making this year’s 900,000 b/d growth seem far too low. Once the rest of the world came out of the COVID lockdown, consumption surged due to pent-up demand. Although this snap-back eventually moderated, Chinese demand could grow far more than expectations for at least the next six months. Analysts are taking for granted that the world’s second-largest oil consumer has let its 1.3bn population out of lockdown. The impacts could be massive.
We also believe that China will soon begin a period of sizable stimulus to help assuage the public’s discontent following two years of restrictive lockdowns and weak economic growth. We believe Chinese oil demand can conservatively run 450,000 b/d ahead of expectations, taking global consumption to an astounding 102.7 m b/d.
On the supply side, the IEA expects non-OPEC+ supply growth of 1.8 m b/d, split almost evenly between the US and the rest of the non-OPEC+ world. Compared with Q4 production, the report implies that full-year US production will average 400,000 b/d ahead of the Q4 2022 supply. While this number may be high, we believe it is in the right ballpark. The IEA expects non-OPEC+ outside the US to average 600,000 b/d ahead of Q4 2022 figure, which we think is too high by half.
The IEA projects OPEC+ production will fall 600,000 b/d year-on-year to average 51.5 m b/d – more than 1 mm b/d below the Q4 2022 reading. This figure assumes Russian production will fall by 1.2 m b/d year-over-year compared with Q4 2022. The truth is that neither Goehring & Rozencwajg nor the IEA can know with any certainty. Russia has already announced a 500,000 b/d production cut in retaliation against the NATO-led $60 price cap. While some pundits have argued that this cut signals unsold crude, we believe it may signal field fatigue instead.
Between 2010 and 2012, Russia drilled, on average, 16,000 km of new oil wells per year, resulting in annual net production growth of 170,000 b/d. Drilling increased by 65% to 26,500 km per year in 2021 and 2022, but annual net production growth fell slightly to 165,000 b/d. We estimate the average kilometer of new drilling went from bringing on 70 b/d per km to 40 b/d – a fall of nearly 40% over a decade. Since most Western oil field service companies have left the country, drilling productivity will likely fall more. For those interested in a much more in-depth discussion on the Russian oil industry and its reserve replacement problems, please refer to our Q4 2021 letter, “The OPEC Spare Capacity Issue Part 1: The Russian Dilemma.”
According to the IEA’s base case figures, 2022 will be in deficit by 600,000 b/d. Adjusting for the “missing barrels” and pent-up Chinese demand, we believe the deficit could widen to 1.4 m b/d, leaving inventories at four-decade lows by the end of the year.
Investors are focusing on all of the wrong things. Stories of a near-term energy glut dominate headlines. Near-term demand is always noisy and prone to reversion. Longer-term, we believe the oil market will be dominated by the massive lack of upstream capital spending that has been chronic for nearly a decade. We expect the ongoing energy crisis will persist until investors regain interest in conventional energy and encourage companies to drill. There will be volatility, as always; however, we believe crude prices are headed much higher.
Intrigued? We invite you to download or revisit our entire Q4 2022 research letter, available below.
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