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The strong pent-up demand for travel, coupled with the onset of summer driving season in the Northern Hemisphere, has brought about an increase demand for oil. OPEC is expecting global oil consumption to climb by 3.1 million barrels a day to an average of 101.8 million a day in the second half of this year, surpassing pre-Covid levels.
As the Russia-Ukraine war deepens, Russia now faces a seaborne-oil embargo covering most European imports, which will further disrupt flows and exacerbate oil shortages.
OPEC producers are struggling to meet production quotas, with only Saudi Arabia and UAE having spare capacity. Nevertheless, the extra production from Saudi Arabia and the UAE is offset by an even greater decline in production from Iraq, Libya, Nigeria, as well as Russia.
Underinvestment precedes a commodities supercycle. Over the past decade, ESG considerations have resulted in a significant reduction in investment into the oil and gas industry. Greater investment is needed to grow the supply and de-bottleneck the system to accommodate more demand growth.
Where it stands, the current demand-supply dynamics are supportive of high oil prices. We think that high oil prices are here to stay, with the possibility of oil reaching USD 150 per barrel.
US West Texas Intermediate (WTI) Crude topped USD 120 a barrel last month amidst doubts that a higher output target for OPEC oil producers would help to ease the tight supply. Going forward, the reopening of borders and the return of air travel would bring about stronger demand for oil, while geopolitical tensions, capacity constraints and an under-investment in the sector means that supply is expected to remain tight for the remainder of the year, supporting high oil prices.
Strong pent-up demand for oil as travel makes its long-awaited return
The increase in global oil consumption can be attributed to the pent-up demand of air travel after lockdowns and the lifting of many border restrictions, as people are eager to travel and make up for the lost time in the past two years.
Total demand for air travel in April 2022 (measured in revenue passenger kilometres) was up 78.7% compared to April 2021 and slightly ahead of March 2022’s 76.0% year-over-year increase (Table 1).
Table 1: Air passenger market detail for April 2022
|
April 2022 (% YOY) |
World Share |
Revenue passenger kilometers (RPK) change |
|
Total market |
100% |
78.7% |
|
Africa |
1.9% |
108.4% |
|
Asia Pacific |
27.6% |
-25.4% |
|
Europe |
25.0% |
301.6% |
|
Latin America |
6.5% |
139.2% |
|
Middle East |
6.5% |
238.1% |
|
North America |
32.6% |
78.5% |
|
Source: IATA, iFAST Compilations Data as of 30 April 2022 |
||
The April air passenger data is cause for optimism in almost all markets, except China, which continues to severely restrict travel. Nevertheless, as global travel makes its long-awaited recovery, it brings with it a stronger demand for oil.
Similarly, the global demand for oil is expected to rise in 3Q22 as the Northern Hemisphere’s summer holiday season begins. The US peak driving season traditionally begins on Memorial Day weekend at the end of May and ends on Labour Day in September, which would likely cause an upward pull on oil demand. In spite of fears about soaring fuel prices potentially denting demand, some 40 million Americans travelled by road, an increase of 8.3% on the same weekend a year earlier.
As such, busier road and air traffic have boosted the demand for road and jet fuel (Figure 1), sending oil prices higher. A strong demand for oil is expected going forward, as according to the Organization of Petroleum Exporting Countries (OPEC), global oil consumption is expected to climb by 3.1 million barrels a day to average 101.8 million a day in the second half of this year, surpassing pre-Covid levels.
Figure 1: Stronger jet fuel demand
Supply fears have exacerbated
As part of new sanctions against Russia, EU members agreed on a partial crude-oil ban that covers more than two-thirds of oil imports from Russia. The embargo covers Russian oil brought in by sea, allowing a temporary exemption for imports delivered by pipeline, a move that was crucial to bring landlocked Hungary on board a decision that required consensus. Moreover, the 27-member EU agreed to slash Russia oil imports by up to 90% by year’s end.
Figure 2: Russia is the largest supplier of energy for Europe
As Russia’s exports fall sharply, the country’s facilities will cut production. The output which stood at just over 10 million in May, will drop by around 1 to 2 million barrels a day according to analyst estimates, with the International Energy Agency going as fair as to suggest a drop of 3 million daily.
OPEC has committed to accelerate output increases following repeated calls to pump more oil. The producer group said it would add 648,000 barrels a day for July and August, about 50% more than the increases seen in recent months.
However, the group has struggled to meet its supply targets, raising doubts about whether it would be able to meet this goal. Take for instance, OPEC's production in May this year was down 176,000 barrels per day from April, with production from Libya, Nigeria, Iraq, Gabon, Venezuela, Iran, and Equatorial Guinea reporting a decline in production (Table 2).
Table 2: OPEC crude oil production in May
|
‘000 barrels per day |
April 2022 |
May 2022 |
Change May/Apr |
|
Algeria |
1,004 |
1,011 |
7 |
|
Angola |
1,175 |
1,176 |
1 |
|
Congo |
262 |
270 |
7 |
|
Equatorial Guinea |
96 |
94 |
-2 |
|
Gabon |
198 |
166 |
-32 |
|
IR Iran |
2565 |
2544 |
-20 |
|
Iraq |
4,426 |
4,405 |
-21 |
|
Kuwait |
2,660 |
2,687 |
27 |
|
Libya |
893 |
707 |
-186 |
|
Nigeria |
1,306 |
1,262 |
-45 |
|
Saudi Arabia |
10,364 |
10,424 |
60 |
|
UAE |
3,015 |
3,046 |
31 |
|
Venezuela |
719 |
717 |
-2 |
|
Total |
28,684 |
28,508 |
-176 |
|
Source: OPEC Monthly Oil Market Report Data as of June 2022 |
|||
Where it stands, Saudi Arabia and United Arab Emirates (UAE) are about the only OPEC nations with spare capacity, with roughly another 2.4 million daily barrels of unused output to deploy according to the International Energy Agency. This is unlikely to keep pace with the expected incremental amount of 3.1 million barrels a day on average projected by OPEC (Figure 3).
Figure 3: Spare capacity supply is unable to keep pace with demand
Moreover, the current agreement terms between OPEC do not enable these nations to compensate for others. It is also expected that the extra spare capacity from Saudi Arabia and the UAE, will be offset by an even greater decline in production from Iraq, Libya, and Nigeria. Not to mention, the loss of Russia oil supply will continue to weigh on global oil supply.
As oil struggles to keep pace with demand, the world ends up drawing down its existing oil stocks. Crude oil inventories are falling (Figure 4), given that the White House has sold almost 115 million from the US Strategic Petroleum Reserve, with the releases surging to a record high of one million barrels per day since mid-May.
Figure 4: Crude oil inventories have fallen significantly
Longer-term structural trend of underinvestment is bullish for the sector
Underinvestment always precedes a commodities supercycle. It is precisely this underinvestment in the energy space that has been the key contributors to the shortage of fuels.
The underinvestment is unsurprising, given that the oil and gas industry has been one of the most disliked and out-of-favor sectors in recent years. Environmental, Social, and Governance (ESG) mandates to restrict capital to the industry posed major challenges for a sector that badly needed new investments to keep up with the growing demand.
The result is that annual investment in upstream oil and gas peaked at USD 780 billion in 2014. Since then, the highest annual spending seen was in 2019, which amounted to USD 483 billion, just 62% of 2014 levels (Figure 5). More recently in 2021, annual investment in upstream oil and gas amounted to only USD 351 billion, despite the fact that the world is still highly reliant on these fossil fuels which up 80% global energy needs.
Figure 5: Falling investment in the fossil fuel industry
Not to mention, just two years ago, margins for refining crude were in the dumps due to the pandemic, and about four million barrels a day of refining capacity, including those owned by Shell (NYSE:SHEL) and Exxon Mobil (NYSE:XOM) have been earmarked for shutdown since the Covid-19 outbreak.
While the situation has reversed dramatically, with refinery margins exploding as illustrated by higher crack spreads (difference between the purchase price of crude oil and the selling of finished products, such as gasoline and distillate fuel) (Figure 6), the waves of refinery closure have already done their damage, and could continue to persist as countries pursue net-zero emissions targets.
Figure 6: Oil refiners are enjoying their best
ever processing margins
All in all, prior underinvestment takes years to rectify, and greater investment is needed to grow the supply and de-bottleneck the system to accommodate demand growth. ESG concerns continue to prevent companies from investing in this space, and we do not foresee that investments will start flowing into this sector, ensuring a persistent supply deficit.
Key investment risks
Recession risks: Recession fears have heightened after the US Federal Reserve approved the largest interest rate increase in more than a quarter of a century to contain a surge in inflation. A demand slowdown for oil may come from an economic recession that stems from the current geopolitical conflict and inflationary dynamics.
Policy risks: US Senate Finance Committee chair Ron Wyden has plans to introduce legislation setting a bill which would apply a 21% additional tax on excess profits of oil and gas companies with more than USD 1 billion in annual revenue.
Meanwhile, UK Chancellor Rishi Sunak has announced a one-off “windfall tax” on the country’s oil and gas industry. The new levy will be charged on the profits of oil and gas companies at a rate of 25%, before being phased out when commodity prices return to more normal levels.
High oil prices are here to stay, with the possibility of oil reaching USD 150
Crude oil could surpass USD 150 this summer, driven by the confluence of pent-up travel demand, busier road traffic, inventory shortfalls and OPEC’s output constraints. Not to mention, higher crack spreads may induce refiners with spare capacity to ramp up production, leading to increase demand for crude oil and higher crude oil prices.
Beyond this, China’s recovery in the event of easing lockdowns would likely be another positive catalyst. In fact, we have started to witness some signs of this earlier (Figure 7), when China had announced an end to its two-month long Covid-19 lockdown in early June before re-imposing Covid-19 restrictions in major cities.
Figure 7: Road congestion and subway rides
As such, the current demand-supply dynamics are supportive of high oil prices. Fundamental improvement in supply capacity is likely to take some time, given the lack of investment into this space as witnessed in the past decade. Meanwhile, demand for oil is likely to remain robust in spite of the high prices, due to pent-up travel demand.
With this, investors may wish to consider the Blackrock World Energy Fund A2 USD, if they are seeking a dedicated fund involved in the exploration, development, production and distribution of energy.
Investors may similarly wish to consider the JPMorgan Funds - Global Natural Resources A (acc) USD Fund, which invests in natural resource companies, such as those involved in oil and gas exploration and production, as well as in metals and mining. Alternatively, investors can also consider the Blackrock Natural Resources Growth & Income A2 USD Fund which is well-diversified across different commodities, with an allocation into the mining, energy, and agriculture sectors.
(Related article: High oil prices are here to stay, with oil possibly reaching USD 150)
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