Supply and Demand: A Forward Look into Energy Price Drivers

SUMMARY

• OPEC+’s goal is sustaining elevated oil prices.
• US government likely to purchase oil for reserves, boosting demand, in our view.
• We believe US Energy equities are well positioned to take advantage of current prices.

Over the past month, we have seen increased volatility in the global oil markets, with Brent crude oil prices breaking $93/barrel in mid-October before falling back below $85/barrel to start November. We have previously discussed some of the structural US supply characteristics and geopolitics that have contributed to this volatility (See Weekly View from 10/24/23). However, until today we have spent less time on some of the tactical supply and demand factors that we believe drive global oil markets, as well as the energy stocks and bonds we own in our portfolios.

Supply: OPEC+ Needs Higher Prices; US More Efficient, Less Excess Capacity

When focusing on the supply side of the oil markets, there are two major players to focus on, OPEC+¹ and US producers. Combining the US and OPEC+ production accounts for over 70% of the world’s oil supply, but it is their different goals that make them an interesting case study.

Starting with OPEC+, the member-states of the cartel tend to have nationalized oil production. This means that their primary goal is to use the sale of oil to balance their national budgets. On the other hand, US energy companies tend to be profit-driven companies, focusing on shareholder returns. This dichotomy is reflected in the ‘breakeven’ prices for these entities (what minimum price of oil an entity needs to produce profitably). For Saudi Arabia, OPEC+’s largest producer, they require an oil price between $80 and $90 to balance their budget. Comparatively, US oil companies have breakevens below $70 for new wells and below $45 for existing wells.

This difference creates two very different production decisions. Saudi Arabia has committed to continued output cuts through the end of the year. While this may seem incongruent with already elevated oil prices, a supply cut seems very logical when considering OPEC members’ higher breakeven threshold. Because of this we believe that Saudi Arabia and their fellow OPEC+ members will continue similar supply cuts over the next 12 months.

On the US side of production, looking at Chart 1 (right), we can see that US oil production has just eclipsed its early 2020 peak (on a trailing 12-month basis) and producers are likely operating close to full capacity. Additionally, US government regulations provide some natural buffer against other entrants, which gives existing US companies a natural “moat” where they have a cost structure advantage and barriers to competitors entering the market. This only strengthens OPEC+’s ability to influence prices, who could constrain supply over the next 12 months.

Demand: Waiting on the Strategic Petroleum Reserve

When discussing global oil demand, one driver is the US Strategic Petroleum Reserve (SPR). The SPR acts as the US’s emergency oil supply and is used to lessen oil market disruptions in the US, a role it filled last year during the Ukraine conflict. Looking at Chart 2 (below), we can see this drawdown in the SPR since 2021, which has yet to be replenished. We believe this will eventually reverse, as the US will reload at some point to guard against future market disruptions, providing support for our view that oil can stay elevated. With recent increased geopolitical tensions, the need for replenishing the SPR becomes more urgent. This demand should help buffer oil prices against some slowing in the global economy coming from China and elsewhere, in our view.

US Energy and P.A.T.T.Y. – We Remain Bullish on the Energy Sector

Given our view of constrained supply and sustainable demand, we favor the Energy sector and believe that the price of oil will remain elevated over the next 12 months. We also believe the cost discipline and heightened regulatory environment create a wide ‘moat’ for US Energy companies relative to international competitors, which helps explain why we favor these types of companies in our portfolios.

The energy sector plays particularly well into the ‘P.A.T.T.Y.’ (‘Pay Attention to the Yield’) theme that we outlined in our 2023 Outlook. As we mentioned earlier, US energy companies have breakeven prices well below the current price of oil, which translates to positive free cash flows for these companies. These free cash flows can be returned to shareholders through both dividends and share buybacks. In addition, well-capitalized energy companies should be able acquire the assets of firms that have compelling prospects but are challenged by the rise in interest rates.

^{1 Current OPEC members: Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC+ includes nonmembers Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan and Sudan.}

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.