Oil prices have risen for eight straight weeks to roughly $95 a barrel, a seven-year high. Are prices set to break $100 or are we due for a pullback?
While the market has priced in a sizable risk premium for the current state of the Russia-Ukraine tensions (some estimates have it at $6 a barrel1), we really don’t know what is going to happen. We could speculate on the likelihood of different outcomes, but the truth is that it is in Vladimir Putin’s hands. Given that Russia is the third-largest producer and second-largest exporter of oil, it is plausible that prices could reach $120 by the end of the month if tensions were to escalate and disrupt current or future supply.2 However, a climbdown in rhetoric could pare back some of the recent gains and bring prices back toward the $80-$90 range.3
Looking past the sometimes dramatic short-term impact of geopolitical headlines and events, we expect several longer-term factors to dictate the trajectory of oil prices.
Fresh Iran deal could weigh on prices
There are several catalysts that could emerge over the coming months that could weigh on oil prices. The primary one is the prospect of an Iran nuclear deal. While the scope of any potential deal is still unknown, its likelihood has increased in recent weeks. The U.S. State Department went on record saying talks were in the “final stretch”, following on from a similar statement from Russia that said an agreement may be reached at any time.4
A comprehensive deal would potentially allow an estimated 1.3 million barrels a day of Iranian crude to re-enter the market within six months.5 On the low end of estimates, this would shave roughly $7 per barrel off oil prices, on the high end, up to a $15 per barrel.6 A partial deal could bring online roughly 500,000 barrels a day within a few months.7
While we note that an Iranian deal would account for most of a potential negative price shock, there are other factors that could force oil to pare some of its gains and stabilize in the $80-$90 range over the coming months:
• A stronger U.S. dollar: Given that oil is priced in dollars, a strong dollar would put downside pressure on oil prices. In recent quarters, the dollar has been very strong and is currently sitting just 5% below cyclical highs on a trade-weighted basis, aided by increasingly hawkish rhetoric by U.S. Federal Reserve members and increased rate hike expectations.8 Yet similarly hawkish rhetoric by other central banks along with a move higher in foreign rates has effectively limited further rises in the dollar and put a lid on the rally. Further dollar strengthening could weigh on oil prices, but our base case is that it will remain range bound in the near term given the relative convergence of global interest rate policies.
• The return of Venezuelan oil: In recent months, Venezuela has reportedly increased oil production despite disruptive U.S. sanctions. Thanks to Iran, Venezuela’s output has risen 47% since September 2021.9 Over the last year, Iran has provided Venezuela with roughly 8 million barrels of condensate, an ultra-light liquid that is used to make Venezuela’s oil exportable.10 While most of that exportable oil has been redirected back to Iran, additional easing of Iranian sanctions could further increase Venezuelan production and allow for more exportable oil to hit the market. This represents a moderate risk to the oil supply-demand balance in 2022. In addition, the Biden administration is weighing reinstating a Trump-era trading privilege that permits oil companies to accept Venezuelan oil in lieu of debt repayments.11
Structural bull market likely to hold sway over longer term
On the flip side, there are many potential drivers for higher oil prices through 2022 and into 2023 amid a structural bull market that has been years in the making, including:
• Structural tailwinds from chronic underinvestment: The increase in companies shifting focus to ESG initiatives, dividends, buybacks, and debt repayments, has led to chronic underinvestment in oil exploration and development. In 2020, investment in new supply fell 30% as U.S. producers limited spending on drilling and opted to return cash to shareholders.12 A similar story played out in 2021 with upstream investment of just $341 billion, roughly 25% below its pre-pandemic level of $525 billion.13 Ultimately, many U.S. producers have been left incapable of increasing production while current supply runs down. In order to avoid further shortfalls, upstream companies would need to increase their capital expenditure from 4% to 9% by 2030.14 This is highly unlikely, so underinvestment should support oil prices for the foreseeable future.
• Demand to remain robust: In 2021, demand outstripped supply by 2.1 million barrels a day. For 2022, global oil demand is expected to eclipse pre-pandemic levels and rise 3.2 million to a record 100.6 million barrels a day. The market is expecting a build in oil inventories starting in the second quarter of this year as supply growth catches up. However, we see scope for demand to surprise to the upside, while supply may disappoint. First, weekly data has shown above trend demand: In the U.S., seasonal demand is already at record levels, averaging 21.6 million barrels a day in January.15 Potential for further demand upside? Areas of Asia—particularly China—have still yet to see demand return in full, but a recent shift from a covid-zero policy to a slightly more flexible covid-light framework in China should help.
• OPEC’s limited spare capacity: Periods with low spare oil capacity often correlate with rising prices. Currently, OPEC (Organization of the Petroleum Exporting Countries) spare capacity sits at roughly 15% of total production capacity, but that is expected to fall to just 4% by the end of 2022.16 At the same time, OPEC member countries are struggling to ramp-up production to meet the group’s compliance levels. In January, the group added just 50,000 barrels a day, compared to a targeted mandate of 400,000.17 If OPEC members continue to undershoot production levels, then the difference between target production and actual output could amount to roughly 1 billion barrels from the start of 2021 to the end of 2022.18 Undershoots in supply, absent new developments, could further tighten the market in coming quarters.
• Possibility of “demand destruction” still distant: Occurring if prices remain unsustainably high for too long, demand destruction can weaken demand and cause prices to correct. On the low end of estimates, oil would need to reach $120 a barrel, or 25% above current prices for meaningful demand destruction to occur.19 At this level, fuel expenditures as a percentage of GDP would be roughly 5.5%, the same level reached during the 2008 run-up in oil.20 However, on an inflation-adjusted basis, oil would need to reach $150, or 50% above current levels, to hit 2008 price levels and trigger demand destruction.21 Either way, it still seems some way off, suggesting headroom for prices.
While the picture is complicated, particularly in the shorter term, by the geopolitical considerations in Eastern Europe and the Middle East, which will likely drive continued volatility in oil prices, the structural upward drivers are likely to assert themselves over the medium and longer term. Taken together, this supports a bullish narrative for oil prices through 2022 and 2023.
To position for this, we continue to like oil and gas equities, where many of the companies are producing significant free cash flow and returning that to shareholders via dividends and buybacks. Earning dividend income is especially attractive in the current environment of elevated uncertainty and market volatility.
(1) Source: JPMorgan Research, February 10, 2022.
(2) Source: JPMorgan Research, February 10, 2022.
(3) Source: Ibid
(4) Source: U.S. Department of State, Senior State Department Official On the JCPOA Talks, January 31, 2022.
(5) Source: IEA Data, Bloomberg, as of February 15, 2022.
(6) Source: Goldman Sachs, February 11, 2022. Bank of America Global Research, February 11, 2022.
(7) Source: Bank of America Global Research, February 11, 2022.
(8) Source: Bloomberg, February 14, 2022.
(9) Source: JPMorgan Research, February 10, 2022.
(10) Source: Reuters, JPMorgan Research, February 10, 2022.
(11) Source: Reuters, U.S. weighs Chevron request to take Venezuela oil for debt payments, February 7, 2022.
(12) Source: IEA Oil Market Report, February 2022.
(13) Source: International Energy Forum, IHS Markit, December 7, 2021
(14) Source: FT Commodities Global Summit, JP Morgan Research, June 15, 2021.
(15) Source: Bank of America Global Research, February 11, 2022.
(16) Source JPMorgan Research, February 10, 2022.
(17) Source: Bloomberg, OPEC, February 11, 2022.
(18) Source: IEA Oil Market Report, February 2022.
(19) Source: Goldman Sachs Research, October 24, 2021.
(20) Source: U.S. Energy Information Administration, October 24, 2021.
(21) Source: RBC Capital Markets, February 14, 2022.
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