5 Reasons to Expect Higher Oil Prices

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Why we're constructive on oil

Not many investors have been bullish on the price of oil recently, but Allianz Global Investors has had a constructive view of the industry for the past 12-18 months. Now that both members and non-members of the Organization of the Petroleum Exporting Countries (OPEC) have renewed their commitment to limit production in an attempt to boost prices, it's a good time to review the prospects for oil. Here are five reasons why we think the price of oil will turn around – and why investors should consider positioning themselves to take advantage of the opportunity.

1. Global demand for oil is reassuringly stable

Although the International Energy Agency (IEA) lowered its predictions for oil-demand growth in 2017 from 1.4 million barrels per day to 1.3 million, global demand has remained reassuringly stable. At the end of 2016, the world consumed slightly more than 97 million barrels per day, making the IEA's modest downward revision look relatively inconsequential and still representative of healthy growth. At the same time, oil inventories have been decreasing and global economic growth is buoyant. Taken together, these factors should underpin a steady demand for oil despite higher prices.

It is important to note that a rising oil price has a downside as well, given that it functions as a tax on consumers and the global economy in general. Higher prices may crimp consumer spending and drive inflation through the economy. This effect can be amplified by currency movements globally, particularly given that oil is often priced in US dollars. For example, the post-Brexit fall in the British pound had the effect of re-pricing oil to the equivalent of $70 per barrel by the time it reached consumers at the pump.

Energy production growth is slowing

Percentage of energy production (million tons of oil equivalent) growth per decade

Source: International Energy Agency as of 12/31/15.

2. Multiple factors will constrain the oil supply

Global supply levels became much more difficult to assess in November 2016, when members and non-members of OPEC agreed to reduce production as a way to drain the oversupply of oil and boost prices. On May 25, this agreement was extended through March 2018. While analysing the actual effectiveness of this agreement will continue to be challenging, there is little doubt that it has improved the supply/demand balance.

Moreover, many OPEC nations are effectively petro-states that derive most of their government financing through the taxation of oil and gas revenue. When the price of oil is threatened, their institutions become vulnerable – and given that oil prices have been low for some time, many of these countries have experienced serious issues:

  • Mexico, already under pressure from the trade and immigration policies of President Donald Trump, has seen its revenues and financial flexibility drop sharply as production and profits fall.
  • Venezuela, which produces around two million barrels of oil per day, has struggled with hyperinflation and appears on the verge of collapse as its economy runs out of cash, credit and food.
  • Nigeria is suffering not only from a weak, inflation-prone currency and economy, but from serious security problems in its oil-producing delta regions.
  • Oil production across the Middle East is also being threatened by continuing destabilization in countries such as Libya and Iraq – which may get worse before it gets better.

The fragile state of many petro-states is one of the reasons why OPEC is aiming to boost prices by cutting production. These issues have also ratcheted up geopolitical tensions – already at an elevated level thanks to US airstrikes on Syria and missile testing in North Korea. If markets become increasingly nervous, we expect to see a further premium on prices.

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