Global crude prices have soared on supply worries caused by Russia’s invasion of Ukraine. The conflict is highlighting the tightness of crude stocks and persistently robust demand (short-term disruptions notwithstanding). With oil prices likely to stay high, support for energy stocks could continue, says Research Analyst Noah Barrett.

Key takeaways

• With Russia a top-three producer of global crude, the country’s invasion of Ukraine has created worries about a steep drop in oil supplies at a time when demand for crude continues to recover from pandemic lows.
• Indeed, the Russia/Ukraine conflict has cast a light on the tightness of global oil supplies after years of under-investment by the energy industry. Meanwhile, demand for crude is expected to rise over the coming decade.
• In our view, the supply/demand imbalance could keep oil prices elevated and create a positive backdrop for the energy sector, particularly exploration and production companies.

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Noah Barrett: So, prior to the Russia/Ukraine conflict, the oil market was overall pretty tight. So, we saw some supply coming back in from OPEC+.¹ They were bringing back about 400,000 barrels every month as part of their coordinated cuts. But when you look elsewhere around the world, there weren’t a lot of sources of supply growth. So, capital discipline, or I should say production growth discipline in the U.S., has been holding. And while we do expect to see U.S. production increase a little bit year over year, we certainly weren’t going back to the kind of boom days of the unconventional oil cycle in the U.S. And then, if we look at the third bucket, so ex-OPEC+, ex-U.S., everywhere else in the world was struggling to grow. And so, with oil demand continuing to recover off the pandemic lows and the view that oil demand would be pretty strong through 2022 and into 2023, particularly as some things still had yet to come back – so, think about business travel, international leisure travel – those were all pretty nice tailwinds on the oil demand side.

I think the volatility we’ve seen in the oil market is just a reflection of tightness on the supply side. And when you have a country like Russia – a top-three producer in the world that exports 5 million barrels/day of crude and then 2 million barrels/day of refined products – when you take that big chunk out of the supply side, that oil just can’t be replaced in short order. And so, it’s a real concern for global balances of how we’re going to replace that Russian oil. On the demand side, we did see some pullback or some fears over lockdown measures in China. But overall, the demand story for this year and as we move into 2023 is still pretty robust. So, again, if I kind of think about overall markets, they were tight before Russia/Ukraine, and the actions of the past month have only highlighted some of the problems we might see both on the supply side and meeting that robust demand recovery we continue to see.

If we take a view that oil prices will remain range-bound to, say, between $80/barrel and $120/barrel, I think that’s actually a pretty healthy price for the oil industry. So, we like the upstream part of the sub-sector of the energy market because we think those companies, they’re most levered to higher oil prices. The capital discipline that we’ve seen is sticking. The companies remain committed to generating sustainable free cash flow and, most importantly, returning a significant portion of that free cash flow from higher oil prices back to shareholders. So, we think upstream, again, even if oil prices were to pull back to that $80 or $90 range, they’re still generating a lot of free cash flow, generating high returns and, again, shareholders are participating in that upside. Other areas of the market: The integrated oil companies, they also benefit because they do have large upstream operations, but it’s a little bit diluted because they do have downstream and some midstream in some chemicals businesses, as well. So, it is torqued to higher oil prices, just a little bit more diluted than, say, buying pure exploration and production.

So, my view on global oil demand is that it’ll continue to grow through the end of the decade, at a slow pace, but we will see growth. I think peak oil demand we will see at some point in the 2030 to 2040 period. I know that’s a big range, but when we do see peak oil demand, I think the declines from the peak will be relatively shallow.

I think one thing the pandemic taught us is how much oil and natural gas the world consumes on a daily basis and how reliant we are on that. Even as we move towards alternative energies, the energy transition is going to be incredibly oil intensive. If we think about all the materials that go into making solar panels, wind turbines, moving all that equipment around the world, that uses a lot of oil. And so, with no real short-term solutions on the supply side – the industry has been under-investing for quite some time – and a constructive outlook on the demand side, I think energy markets will remain tight, and I would expect periods of volatility but also periods of comfortable oil prices. Again, maybe in the $80 to $120/barrel range, where most companies generate returns, generate a lot of cash flow at those levels. Based on our outlook for both supply and demand, we think the outlook for energy equities is positive from here.

 

¹OPEC = Organization of the Petroleum Exporting Countries. OPEC is an organization of 13 major oil-producing countries that aims to coordinate global petroleum prices. OPEC+, formed in 2016, includes 10 additional countries. 

Energy industries can be significantly affected by fluctuations in energy prices and supply and demand of fuels, conservation, the success of exploration projects, and tax and other government regulations.

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