Oil prices have been pushed higher, as weaker supply has collided with growing demand from China’s reopening. The supply/demand imbalance is likely to endure, says Mark Hume, co-manager on the BlackRock Energy and Resources Income trust.
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
The oil price has been volatile since the start of the summer. Supply cuts from Saudi Arabia and Russia, plus increased demand from China’s reopening, pushed prices up from $70 a barrel to over $90 by the end of September.1 Its strength prompted fears hard-won gains on inflation could be reversed across the world.
Since its peak, however, oil has traded in a relatively narrow range. This is in spite of the risk that war in Israel and Gaza will destabilise the Middle East, disrupting oil supply. The oil price is now back below $80 a barrel, with Chinese economic data creating worries over demand, and supply appearing to hold up.2
However, for our trust, we are more focused on the long-term trajectory for oil, and therefore for the companies that supply and distribute it. There are a lot of factors at play. While in the short-term geopolitical tensions could impact the market, alongside economic growth factors, in the longer-term factors such as the speed and success of the energy transition, and whether that creates less demand for oil, may be more important.
Rising geopolitical risks
The world has become more fragmented in recent years, of which the Russia/Ukraine conflict is only the most recent manifestation. There is competition for technology leadership between US and China, plus fears over China’s long-term relationship with Taiwan. With the recent attacks on Israel, we are witnessing a major humanitarian tragedy unfold in the Middle East. This increase in geopolitical risk may add a risk premium to the pricing of some commodities, including energy.
There is also likely to be rising global demand, supported by the ongoing reopening in Asia. Although interest rate increases are exerting a drag on growth, economic expansion continues to surprise markets with its resilience. The link between economic growth (GDP) and oil demand has yet to be broken. Faster growing economies, such as China and India have seen demand for oil increase and coupled with resilient oil demand in the US and Europe, this is leading global demand for oil to reach new highs.3
Equally, the growth in renewable energy is doing little to dent demand for oil. 2022 was a record year for renewables growth, but it did nothing to displace fossil fuels, which still accounted for 82% of supply, according to the Statistical Review of World Energy report, issued by the Energy Institute.4 Renewables, excluding hydropower, accounted for 7.5% of global energy consumption. As such, there are no immediate signs that the move to cleaner energy is dampening fossil fuel demand.
Supply
We believe this situation is likely to continue. Energy transition is not an on-off switch. While it would be fantastic if the world could switch to renewables overnight, there needs to be enormous investment into the grid, into infrastructure and into new sources of renewable supply. There will need to be bridging fuels, while we move to a lower carbon world.
Corporate capital discipline has constrained investment in new oil production projects, which is leading to higher free cash flow generation for energy companies. Energy companies have favoured higher dividends and share buybacks rather than reinvest cash flows in new oil production.
While there are some sources of new supply, including – potentially – from the UK, as the current government grants more oil and gas licences, these are piecemeal and unlikely to move the dial on the oil price globally. The North Sea Transition Authority, which issues the UK licenses, says it takes an average of five years for wells to reach production.5
The underinvestment in new oil and gas supply will mean that whether oil demand peaks, or peaks and declines, supply will struggle to keep up with almost any demand scenario. Our view is that oil prices are likely to stay higher for longer as a result.6
Against this backdrop, oil supply fundamentals remain supportive. We expect oil market supply to remain tight given continued production capex discipline. We also believe that major oil-producing countries such as Russia and Saudi Arabia will continue to limit supply to bolster the oil price. In particular, Saudi Arabia has an ambitious economic diversification plan,7 which relies on the oil price remaining relatively high. Its aim is to ensure the oil price is high enough to make profits, but not so high that it kills off economic activity.8
Against this backdrop, we believe it is important to keep a balance between the energy transition and legacy fuels in the portfolio. At the moment, we still see value in the oil and gas providers and they are still a meaningful holding in the BlackRock Energy and Resources Income trust.
Sources:
1 Trading Economies – Crude oil – 29/11/23
2 Reuters – Oil prices ease awaiting china data - 07/11/23
3 Reuters – IEA raised forecast for crude oil demand in 2023- 16/11/23
4 Reuters - Renewables growth did not dent fossil fuel dominance in 2022 – 26/07/23
5 FT - UK starts new round of licences for North Sea oil and gas – 29/11/ 23
6 Asset TV - Investment Trust Virtual Showcase – 02/11/23
7 IMF - Saudi Arabia's Economy Grows as it Diversifies – 28/09/23
8 DirectorsTalk – Mark Hume asks “Is slower growth a problem?” - 14/06/23
Risk warnings
Investors should refer to the prospectus or offering documentation for the funds full list of risks.
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
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Description of Fund Risks
Counterparty Risk: The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
Currency Risk: The Fund invests in other currencies. Changes in exchange rates will therefore affect the value of the investment.
Emerging Markets: Emerging markets are generally more sensitive to economic and political conditions than developed markets. Other factors include greater 'Liquidity Risk', restrictions on investment or transfer of assets and failed/delayed delivery of securities or payments to the Fund.
Gearing Risk: Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.
Investments in Mining Securities: Investments in mining securities are subject to sector-specific risks which include environmental concerns, government policy, supply concerns and taxation. The variation in returns from mining securities is typically above average compared to other equity securities.
