01 Aug The Crude Oil Conundrum
As published in Business Day on 1 August 2023
JD Hayward chats to Michael Avery on Classic Business about the importance of crude oil as a raw material input to all industrial activity and why it is set to benefit from positive long-term fundamentals.
Crude oil is one of the most important, if not the single most important raw material input to all industrial activity. However, even though analysts have more than 150 years of international trade to go on, they are still very divided on what the current price of oil should be.
One group of analysts (including Facts Global Energy and Rystadt Energy) believe that crude oil prices will recover again to reach almost $100/barrel by the end of the year. Another equally credible group of analysts (including JP Morgan and the US Energy Information Administration) don’t expect the oil price to break through the $80 mark.
For seven decades, global oil supply, and, as a result, oil prices, has, to a large extent, been controlled by the OPEC group. The 13-member alliance controls about 30% of the world’s oil production and, crucially, owns a massive 80% of oil reserves.
Chart 1: OPEC share of world crude oil reserves (2021)
The price of Brent crude oil has been a roller coaster over the last three years. The Russian invasion of Ukraine in February last year sent it rocketing to an intra-day high of $130/barrel, only to come crashing back down to the low $70’s/barrel territory. Then there was the brief dip in future oil contracts below $0 in April 2020 as demand collapsed during the pandemic.
This fluctuating price is not ideal for countries whose entire budget relies on the oil price and thus OPEC adjusts supply, within reason, whenever they feel the price is too low. The group made significant production cuts in October 2022 and April and June this year. OPEC+ also announced a reduction in production by another 1.4 million barrels per day starting 2024. The IEA voiced its concern about the potential impact on production costs on a market that was already set to be tight in the second half of 2023.
Chart 2: Brent crude oil price per barrel (Feb 2020 – June 2023)
Global oil demand is roughly 100 million barrels per day so, in total, these cuts add up to almost 6% of global supply. On the opposite end, Russian oil – vital for financing their war effort – has continued to find a way into the market, mainly via Asian buyers. Data from Kpler Research indicates that Chinese imports of Russian crude averaged 1.59 million barrels per day in March 2023, up 68% from the same period in 2022. The result is that prices have perhaps not reacted as fast as OPEC would have liked, but at some point, they must. Once recessionary fears abate and when (if) Chinese manufacturing numbers finally ramp up, the normal economic principle of demand outweighing supply, leading to rising prices, must prevail.
Clearly the market expects the demand-supply imbalance to flow through to price at some stage, but trying to time this is a difficult task. One factor alone – the duration of the Russian war – could impact this timeline by months, if not years. Thus, trying to pinpoint the price of Crude in six months from now is a futile exercise.
Given our reliance on OPEC oil in the near term (and by near, I mean the next decade), the price of oil will likely gravitate towards whatever Saudi Arabia, as OPEC’s producer-in-chief, needs it to be because its fiscus largely depends on oil revenues. Consensus is that the kingdom needs the price of Brent crude to be more than $80/barrel to cover the government’s spending bill – but this number is hard to verify.
The longer-term (decade+) equation is even murkier, and will, to a large extent, depend on how successful countries are in achieving their long-term sustainability goals and whether there is sufficient oil production to meet demand. While there is no shortage of commitments from major governments and corporates around the world to shifting to renewables, executing on all of these is another story. The International Energy Agency (IEA) has identified three different scenarios for future energy usage, based on how effectively these commitments are met. Their base scenario sees global oil demand still forecast to rise by 3.5 million barrels per day by 2025 in contrast to the 3 million barrels per day decline needed to meet the World Energy Outlook’s Sustainable Development scenario.
Chart 3: Global primary energy consumption (by source)
On the other side of the equation, supply will be impacted by the underinvestment in future crude oil production, as Western oil conglomerates have faced increased pressure from activist shareholders to clamp down on any new non-renewable’s capex. This has not had a major effect on the profits of the big oil conglomerates, which have actually benefitted from capex spend being slashed. It has, however, had a clear effect on downstream oil services companies, like Schlumberger, Halliburton, and Baker Hughes whose profits have collapsed as they are tied to oil exploration.
Thus, while short-term oil prices are largely a function of OPEC’s decision to open or close the taps, in the long-term market fundamentals will come to the fore. These are likely to be favourable as a result of sticky demand and a decade-long underinvestment in oil exploration, which is only now beginning to correct itself. Oil services companies, which are a geared play on a rebound in oil capex spending, stand to benefit disproportionately from this trend.
About the author
James Hayward BEng (Civil)
James, or JD as he prefers to be known, is an equity analyst in the global investment team, having joined Flagship in 2021. At the completion of his degree, JD worked in the engineering and fintech start-up industries while pursuing further studies in investments. JD holds an Engineering degree from Stellenbosch University and has passed all 3 levels of the CFA exams.