RBC Brewin Dolphin’s Janet Mui: Energy price volatility is here to stay

The rally in the oil prices since June has been mainly driven by the extended production cuts by Saudi Arabia keeping supply tight.

More recently, the tragic events unfolding in the Middle East raises the potential for supply disruption.

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Meanwhile, the Energy Information Administration’s (EIA) estimate for oil demand for this year has been revised up. It looks like oil consumption will outpace supply for the reminder of the year, so oil prices are likely to remain supported.

It is best to avoid the embarrassment of wrongly forecasting where oil prices will be in six to 12 months’ time, let alone in five to ten years’ time.

But with ongoing supply constraints due to the significant scale back in fossil-fuel related investments and the challenge of a smooth transition to net-zero carbon emissions, it is fair to expect that energy price volatility will be with us for longer than we wish.

There is a saying that the cure for high oil prices is high prices. That is certainly true on the demand side of the equation as higher oil prices is a direct erosion of purchasing power.

Were oil to hit $100 or higher, it will act to reduce demand and ultimately bring prices lower.

The implications on the supply side are more complicated and the market dynamics have shifted.

The standard playbook reads that higher oil prices will encourage producers to increase supply.

But given the recent reaction from Saudi Arabia, there is evidence OPEC+ will retain a cautious and disciplined stance, particularly as the macro environment remains uncertain.

Due to the intense focus by capital markets on decarbonisation, there has been a substantial decline in the capex to sales ratio for the global listed energy sector, from almost 14% in 2015 to below 8% now.

Take the UK for example.

Oil & gas operators have warned that the Energy Profits Levy will severely dampen investments in the North Sea.

Despite surging oil prices, we are seeing a scenario where hydrocarbon exploration and investment is going the opposite direction, and this will be a structural issue.

The insufficient drilling activity by marginal producers is an issue as well.

There is also ongoing reluctance by US shale oil and gas producers to ramp up supply even though prices are highly attractive.

According to data from Baker Hughes, US oil and gas rig counts are currently 619, about half the number when oil prices were at similar levels back in 2015 and well below the peak of over 2000 rigs more than a decade ago.

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This under-investment in fossil fuel supply, before a significant transition to renewable energy is completed, could result in an extended period of tight supply and bouts of energy price volatility.

A near-term concern is that after the release in the US Strategic Petroleum Reserve (SPR) in 2021 and the war in Ukraine, the SPR currently stands at around 350 million barrels, which is the lowest level since 1983.

This significantly reduces the cushion the SPR may provide if there is a new oil price supply shock.

What does it mean for portfolios? It is true that energy stocks had a strong run last year, but the sector is still 38% cheaper versus the broader market from a historical forward P/E perspective.

This reflects the structural headwinds and secular weak growth that markets are pricing in because of peak oil demand from net-zero transition.

For many investors, this is a predominant and understandable reason not to own energy stocks.

For portfolio diversification purposes, having around neutral exposure to global energy sector stocks may act as a hedge in case of an oil price shock and high likelihood of future price volatility.

It is true that interest rates may have reached their peak in major economies, but we are likely to be in a higher rate for longer environment.

Against this backdrop, energy sector is a low-duration play that can hedge against more interest rate or inflation-sensitive secular growth exposure investors may have elsewhere in portfolios too.

Janet Mui is head of market analysis at RBC Brewin Dolphin

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