Oil Bulls Are Dancing in the Dark.
Reprinted from the FT – 20/06/2021
Huge uncertainty clouds the outlook for supply and demand.
Investment managers who trade in oil companies rather than oil prices still appear to be in a deep slumber. With oil prices climbing well above the $70-a-barrel level they struck before the pandemic, the animal spirits of commodity sector investors should be roaring. Oil traders are certainly excited with executives and hedge fund managers predicting that a return to the $100-a-barrel era may not be so far away.
Brent, the international benchmark, reached $74 a barrel this week while US crude touched $72. Under-investment has restrained supply in the sector in advance of peak demand. Crude traders point to expectations of a post-pandemic boom in travel and the wider economy that should stoke demand for the black stuff, whatever the long-term goals of politicians to build back better — and greener. But the fund and investment managers who trade in oil companies rather than oil prices still appear to be in a deep slumber, at least compared with their counterparts in oil futures or physical markets for cargoes. Scratch the surface of the bullish optimism among those trading in oil itself and it soon becomes clear why those fund managers that prefer trading in companies, from “Big Oil” to shale upstarts, do not quite share their optimism.
The problem is that the oil market is, by its own standards, flying largely blind. In normal pre-pandemic times the industry had become pretty good at predicting where demand and supply would roughly be in any given month. Debates tended to focus on whether demand or supply would be a few hundred thousand barrels a day higher or lower. While that could be enough to set the tone for rising or falling prices, it was really a drop in the ocean of a 100m b/d global market. But since last spring the oil market has had to learn to embrace huge swings.
Demand last year fell by 10m b/d globally. It’s coming back fast now, but traders are adjusting to talking in increments of 1m b/d or more, multiples higher than the usual monthly changes. Compounding the issue is the long-term outlook. Demand, most traders and analysts agree, will peak at some point thanks to the growing use of electric vehicles and intervention by governments to turn their citizens away from oil.
Peak demand could be in five years or 15, and if you ask a trader candidly, they’ll say there’s no way of really knowing. That means we could either be heading for a supply crunch — as Big Oil companies scale back investments — or a glut within a matter of years.
You can see the uncertainty in oil contracts for delivery far in the future, which are generally trading at a steep discount to those for delivery today. For traders dealing in the underlying commodity, the uncertainty is manageable. It’s an industry that tends to thrive on volatility and every participant knows the market can be turned on its head by a war or an economic crisis, like in 2008 when oil went from $147 a barrel to $30 in a few short months.
The prospect of a return to $100-a-barrel crude might be enticing but given the big physical traders such as Vitol and Trafigura made a fortune during last year’s coronavirus-induced downturn, the direction of travel is less important than the volatility to their bottom line. But for investors in oil companies? The uncertainty is paralysing. When JPMorgan surveyed its clients last month, it found at least as much trepidation as interest.
While investors might accept that a return to higher prices is a real possibility, they are not sold on how long the move will last, with many expecting a surge rather than a sustained rally. One of the best things that could happen for climate change is a sharp oil price increase that incentivises the move away from fossil fuels.
They also have one eye on US shale. The biggest publicly listed producers in the US shale industry are, for the moment, showing admirable restraint. By finally focusing on boosting profitability and returning cash to investors rather than going on a capital-intensive drilling spree, traders can no longer bank on a significant surge in US output to meet demand growth. But can this new-found discipline really survive a sustained period of prices above $70 a barrel, let alone $100?
The jury is very much out. For equity investors, who need to take a longer-term view of possible returns, the uncertainty is particularly toxic. That could be an opportunity for those who think predictions of the end of the oil age are premature. But it also could partly explain why some investors have been pushing companies from BP to ExxonMobil to think hard about a future where they pump less oil.