The oil price is one of those totemic benchmarks that we constantly fetishize – quite rightly in my view! I think we collectively all tend to underestimate the challenge of moving away from a carbon fuels based economy – our civilisation is still hooked on hydrocarbons (along with sugar!).
But the power of the oil price extends beyond this theoretical, almost intellectual reliance. Because the media is so London based, they tend to ignore the fact that for many ordinary working people the cost of petrol (and home fuel) is perhaps the single most important discretionary item after food. Public transport is amazing in London but in most other places a car is an absolute requirement to participate in the modern economy – and boy does petrol cost a fortune!
And every time the price of petrol increases – as it has in recent weeks – one can feel the collective pain ripple through the suburbs and rural areas which are structured and dependent on oil and gas.
So, it’s against this backdrop that I monitor Brent and WTI prices very carefully. As I’ve discussed quite a few times in this blog my hunch is that we’re probably stuck in a $40 to $60 trading range but I think that investor’s need to keep a careful eye on the more dangerous breakout – oil moving above $60 a barrel.
If this did happen – unlikely as it is – we could see inflation measures shoot up which might, in turn, prompt overreaction by the central banks. This could, in turn, be the spark that ignites the next global recession as central banks hoist interest rates well above a level sustainable by the global economy.
For the record, again, I think the chances of such a breakout are low but as investor’s we need to be vigilant. The obvious signals to watch are the market prices for Brent and WTI but I also keep a beady eye on the equity markets for small telltale signals – and in particular, the share price of UK listed Enquest and US listed Pioneer Natural. Both are highly leveraged plays on the oil market – and both stocks are in my portfolio, although I only have the Enquest shares because its failed to make the interest payment on its bonds. Over the last few months both shares have collapsed in value but both have started moving up again in recent days.
What’s going on? I suspect it’s just the normal volatility you’d expect from small to mid-cap energy stocks. But there is a chance that something more important is happening. Two research reports from last week gives us some clues. I’ll start with a note from analysts at Goldman Sachs. They observe that “global oil demand growth remained very strong through 2Q at 2.25 mb/d yoy, the second highest quarterly growth rate since 2010 (my emphasis). While July-August data has been sequentially softer, it still implies robust demand growth and is coming in line with our 3Q17 forecast of 1.66 mb/d. The strength in oil demand has been notable for its breadth, with strong consumption across both DM and EM economies and with industrial demand catching up to already strong consumer demand. Regionally, oil demand growth has been strongest in DM economies while the acceleration in growth has been most salient in EM economies, where it was dragged down last year by weak industrial activity”.
The Goldman’s team conclude by raising their demand growth forecast to 1.51 mb/d (from 1.45 mb/d) – “although we expect demand growth to gradually slow, the recent beats of realized data vs. our top-down modelling suggests risks remain skewed to the upside….This strength in demand is an important force in the rebalancing of the oil market. In the short term, it has helped absorb Libya and Nigeria’s recovery. Continued strong demand growth would further help OPEC to normalize inventories and gradually increase production from its current curtailed level in 2018”.
Curiously the European equity analysis team at Morgan Stanley have also weighed into the debate, noting that although oil is at a 2 year high, oil equities remain relatively becalmed. The MS report suspects that “investors are tired of the regularity with which they have been whipsawed by the sector in recent years and are inclined to leave well enough alone even though fundamental trends point to strong global demand for oil and moderating inventory. This would partly explain why the Energy sector has badly lagged the rebound in the underlying commodity over the last couple of months.”
The chart below tells the big story – energy equities might now be cheap.
According to MS the sectors, relative valuation has “decoupled from its underlying FCF – there is usually a close relationship. If the latest uptick in the commodity price drives greater confidence in the sustainability of FCF we should start to see the sector re-rate. As a bona fide member of the ‘Value’ community, Energy should also do well if we start to see an upturn in inflation and bond yields.” See second chart below.