Despite surging North American production, oil prices remain both elevated and relevant. Should energy prices rise—either due to supply constraints, rising geopolitical risks or both—higher energy prices will exert a drag on growth, as well as damage both the fiscal and current account positions of some of the world’s largest emerging markets.
We believe that oil markets remain in a somewhat precarious balance, supported by a long-term rise in North American production, but at the mercy of falling production and exports in much of the Middle East and Africa. However, U.S. production growth is likely to decelerate in the coming years, placing more of a burden on OPEC , where rising geopolitical risks put supply increases in jeopardy.
On the demand side, over the long run economic activities and population growth are the key drivers. Oil demand in developed markets is likely to contract on the back of improving efficiency and slower secular growth, but increased demand in emerging markets—driven by urbanization and increasing car ownership—will likely offset this trend.
What does this mean for investors? To begin, we would stick with energy stocks. Even under a scenario where supply and demand remain in balance and oil reverts back to its recent range of $90 to $110 per barrel on Brent crude, investors will want to maintain exposure to energy stocks. Despite outperforming year-to-date, sector valuations still have room to grow. Multiples are still at a discount to their 10-year average and fund positioning is low. In addition, we continue to see good free cash flow and several recent investment projects are beginning to bear fruit.
In addition, investors will also want to consider the significance of oil fluctuations for both country and currency (f/x) positioning. Should oil prices spike, several countries including Turkey, South Africa, Brazil, the United States, India and Indonesia are vulnerable.