Market sentiment in global commodities has improved significantly following the steepest downturn since the Great Depression. Precious metals, industrial metals, and crop prices have experienced an impressive comeback in recent months. But it is crude oil that has staged a truly impressive rebound following its harrowing crash at the height of global pandemic lockdowns.
A combination of increasing oil supply and a global movement toward de-carbonization has weighed significantly on energy supply/demand dynamics and industry sentiment in recent years. Then the pandemic created an oil demand shock worse than any in history. Today, while mobility is still hindered by large-scale lockdowns, it has become somewhat fashionable to declare the obsolescence of liquid hydrocarbons (the refined products and related LPGs made from crude oil that are actually consumed by end users).
Changing road transportation drivetrain systems will undoubtedly be a material headwind to future oil demand but internal combustion engines aren’t going away anytime soon. While electric vehicle and, eventually, green hydrogen market penetration will accelerate in most developed and some emerging economies in the years to come, it may not be until well into the 2030’s before these technologies drive a meaningful decline in overall liquid hydrocarbon demand. In fact, we believe demand, which has historically been underestimated by long range forecasters, will increase modestly by 2030.
At the same time, ultra-loose monetary and fiscal policies are likely to accelerate global GDP growth as COVID vaccines are more widely distributed this spring and summer. We believe liquid hydrocarbon demand is likely to follow expected GDP growth as we potentially enter a new commodities supercycle.
What about supply? A byproduct of the recent demand shock is a rapid shift in capital allocation by exploration & production (E&P) companies that will likely keep a lid on supply. Oil is a depleting asset. As less capital is allocated to drilling due to poor economics, capital constraints, and producer discipline, the result could be a significant supply shock. This is before considering the potential for core resource exhaustion in many U.S. shale basins which drove the majority of recent oil supply growth.
WTI Crude is currently around $60/bbl at the time of this writing which is a two-year high. We think oil can move higher from here. In the past, such a scenario may have enticed E&P companies to turn the spigots back on. We do not believe that will happen today. Rather, capital discipline should prevail as E&P company managements are likely to continue focusing on delivering free cash flow to shareholders in the form of increasing dividends and stock buybacks that are beginning to win over investors. This should be supportive for the stock price of energy companies which will feed into higher equity index and portfolio allocations in the years to come.
Furthermore, a weaker $USD and stronger inflation are likely to accelerate portfolio positioning in commodity-related areas of the market that we believe are currently under-represented in the S&P 500. For instance, the Energy sector has fallen from a peak of around 15% of the S&P 500 in June 2008 to a little over 2% today which matches average domestic equity allocations1. We believe there is room for that weighting to move materially higher. And while many investors have been looking to reduce the carbon footprint of their portfolios, we would not be surprised to see the same investors once again embrace big energy companies that are committing sizable dollars to renewable energy projects. European oil majors have already pumped billions into energy transition projects and U.S. counterparts are beginning to follow.
Stay tuned as we further opine on this topic in our next H&W Newsletter.