Oil Has Rebounded but Energy Equities Have Lagged. Is It over Already?

Energy equities have underperformed the S&P 500 materially over the last five years. While spot oil prices have risen significantly over the last twelve months, longer dated oil prices have not, and energy equities have remained under pressure. The lower oil price environment has forced the companies to focus on improving profitability via cost control and capital restraint and we see this, in combination with rising longer dated oil prices, as positive catalysts for energy equities. We explore these arguments below.

It has been a good twelve months for spot oil prices. Why is the oil price at $70/bl?

Since the start of May 2016, WTI has rallied from under $50/bl to $70/bl. The key drivers of a tighter oil market have been:

Strong global oil demand. Global oil demand is forecast to grow by 1.5m b/day in 2018, to a new high of 99.3m b/day, according to the IEA. A combination of good global GDP growth and inexpensive oil (relative to the first half of the decade) has resulted in demand forecasts in recent years consistently being revised higher. 2018 looks to be no exception to that. The growth this year is mainly expected to come from emerging countries. In the passenger vehicle market in China, for example, we have seen a surge in ownership of SUVs: five years ago they made up 15-20% of new sales, whereas today it is close to 45%. Air travel across the Asia-Pacific region is also surging, thanks to economic expansion, with air traffic up nearly 12% versus a year before. In the five years since 2013, global oil demand is expected to have grown by 7.6m b/day, the strongest period of demand growth since 2003-07.

OPEC supply discipline and political tensions. OPEC compliance with the 1.2m b/day quota cuts that were announced at the end of 2016 has been strong. In our estimation, they are about two thirds of the way on their journey to rebalancing the market. High compliance has been led by Saudi, and supported by a smaller cut from Russia, as both countries work to fix domestic fiscal issues. The tightening effect of OPEC’s planned supply cuts has been compounded by under-investment from OPEC’s poorer members, particularly Venezuela. Venezuelan production is currently estimated to be around 1.4m b/day, down by 0.6m b/day since the start of the year, as deteriorating infrastructure, weak reservoir management and poor relations with foreign partners have combined to lower supply. Most recently, the re-introduction of sanctions against Iran in relation to their nuclear program brings the prospect of a drop in Iranian oil exports later this year.

Controlled US shale oil supply growth. US shale oil is on the rise again, with year-on-year growth of around 1.2m b/day. However, improved capital discipline has filtered through to the US E&P community, with a significant number of larger producing companies favoring dividends or expanded share repurchase programs over unconstrained capital spending and growth. We are also seeing signs of greater oilfield service cost inflation than was generally expected, and the emergence of infrastructure challenges in the prolific Permian basin in Texas. Overall, while the strength in spot oil prices is causing some acceleration of activity, forecasts for US supply growth at any given oil price are no higher today than they were twelve months ago.