A positive view is maintained here on the oil price.

Indeed oil has the potential to act as a catalyst for an escalation of the inflation scare in coming months.

The positive view is based on both booming demand and, even more importantly, a growing lack of supply.

The demand side is definitely coming back strong and should soon rebound to the then record 100m barrels per day level it was running at in 2019 before the pandemic hit.


World crude oil demand

Source: IEA

World crude oil demand has already risen from 83mb/d in 2Q20 to 95mb/d in 2Q21, with demand in the US and China rising from a low of 16mb/d and 12mb/d respectively in 1H20 to 19mb/d and 15mb/d in 2Q21.

China crude oil demand

The one weak area of demand of late has been India but demand should soon pick up there again as Covid cases have peaked.

India petroleum products demand declined from 18.8m tonnes in March to 15.1m tonnes in May and was 16.3m tonnes in June, while crude oil consumed by refineries fell from 21.8m tonnes in January to 19m tonnes in May (see following charts).

India oil demand

Source: Petroleum Planning and Analysis Cell of India (PPAC)

But as important as rebounding demand is the lack of supply in the oil market, as reflected in both declining inventories and continuing backwardation where futures prices are below spot prices because the market demands a premium for prompt delivery.

The spread between Brent crude oil 12-month futures and the spot price has declined from US$16 in March 2020 to a negative US$5.3 at present (see following chart).

Spread between Brent crude oil 12-month futures and spot price

Source: Bloomberg

While US commercial crude oil inventories, excluding strategic petroleum reserves, have declined by 19.1% from a peak of 540.7m barrels in June 2020 to 437.6m barrels in the week ended 9 July and are now 8% below the previous 5-year seasonal average of 476m barrels (see following chart).

US commercial crude oil inventories

Source: Energy Information Administration (EIA)

Total OECD commercial petroleum inventories have also declined by 10.7% or 344m barrels since peaking in July 2020.

OECD commercial petroleum inventories

Source: Energy Information Administration (EIA)

Meanwhile, investment in exploration outside OPEC has been declining since 2014 when the shale boom went bust.

If that was the original trigger for the downturn in investment the escalating political attack on fossil fuels, and the related reluctance by financial institutions to be seen funding such projects, are only exacerbating the lack of supply.

This is likely to lead to a structural decline in upstream investment.

It is also the case that it looks like US shale oil production has peaked for geological reasons in the sense that the best areas have already been fracked.

The US Energy Information Administration’s (EIA) latest Monthly Drilling Productivity Report shows that US shale oil production has declined by 1.39m barrels/day from a peak of 9.22mb/d in November 2019 to 7.84mb/d in June.

Yet shale has been the main source of the growth of non-OPEC production in recent years.

US oil production in 7 shale regions

Source: Energy Information Administration – Monthly Drilling Productivity Report

Interestingly, Igor Sechin, head of Russian oil producer Rosneft and close ally of Russian President Vladimir Putin, warned recently about the growing risk of an oil price spike because of a supply deficit.

Sechin said at the St. Petersburg International Economic Forum in early June: “The world risks a severe deficit of oil and gas … The world consumes oil but isn’t ready to invest in it.” This is precisely the point.

Still, the Russians and Saudis will be wary of too great an oil spike above, say, US$100/bbl or higher because that will only further encourage alternative sources of production.

That said, the risks of just such a spike are growing, most particularly with the continuing attacks on the oil and gas majors by green activists.

The newsflow in recent months has been about various legal and shareholder moves against the oil and gas majors, be it Exxon in America or Shell in Europe.

There was also the extraordinary report published by the International Energy Agency (IEA) in May which effectively amounted to an obituary for the oil and gas industry (see IEA report “Net Zero by 2050: A Roadmap for the Global Energy Sector”, May 2021).

With even the European oil majors under attack, companies that in the recent past have gone to great ESG-inspired lengths to demonstrate their green credentials and related commitment to invest in “renewables”, it is increasingly evident that more is never enough from the point of view of the activists.

But amidst all this noise and the long-term focus on ‘stranded assets’, investors also need to remember the here and now.

And the reality right now is that fossil fuels still account for 83% of world energy demand at a time when demand is likely to surge and it will be harder than ever for the normal supply function to respond to higher prices.

The above is why the oil price remains this writer’s best guess for the catalyst really to escalate the already commenced inflation scare – just as oil was the trigger for the stagflation scares of 1974 and 1979.

This is why markets could be facing the risk of a third oil crisis just when the great and good are proclaiming the end of the oil era.

Meanwhile, it is worth recording that the S&P500 Energy Index has already outperformed the S&P500 by 37% since early November 2020.

S&P500 Energy Index relative to S&P500

Source: Bloomberg

Still cumulative fund flows into the oil producer ETF, SPDR S&P Oil & Gas Exploration & Production ETF (XOP), have risen by only 8% since June 2020 even though that ETF is up 179% from the 2020 low reached last March.

SPDR S&P Oil & Gas Exploration & Production ETF fund flows

Source: Bloomberg

This suggests that most of the move has been driven by short covering whereas in, say, ETFs geared into copper and other industrial metals there has been much more genuine buying as reflected in rising fund inflows.

For example, the Global X Copper Miners ETF, which has risen by 264% from its March 2020 low, has seen cumulative fund flows into the ETF up nine-fold over the same period.

Global X Copper Miners ETF fund flows

Source: Bloomberg

Clearly, the main risk to the above outlook is sudden evidence that vaccines are not effective against new more infectious Covid variants.

While the charts show a rising number of populations vaccinated globally it remains the case that Delta variant cases are surging, particularly amongst non-vaccinated populations.

This is why it will be critical to watch hospitalisation rates in countries with high vaccination rates but also surging Delta variant cases.

Britain is a good example.

The number of Covid patients in hospitals in Britain has risen from 870 in late May to 3,964 on 15 July, while daily new Covid patients admitted to hospitals have risen from 78 in mid-May to 740.

By contrast, the 7-day average daily new Covid cases in Britain has soared from 2020 in early May to 42,900.

UK 7-day average daily new Covid cases and total Covid patients in hospital

Source: Public Health England

The views expressed in Chris Wood’s column on Grizzle reflect Chris Wood’s personal opinion only, and they have not been reviewed or endorsed by Jefferies. The information in the column has not been reviewed or verified by Jefferies. None of Jefferies, its affiliates or employees, directors or officers shall have any liability whatsoever in connection with the content published on this website.

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