Eric Nuttall of Ninepoint Partners says dour economic outlook doesn’t dent four-point thesis for multi-year bull market
This article was contributed by Ninepoint Partners.
With the entire world fearing a widespread recession and global events flipping the global energy market inside out, we’re seeing unprecedented volatility in the energy sector. A sharp sell-off has now depressed the index by almost 30% from its June high, prompting the question on everyone’s minds - where is the market headed next?
While some of this weakness can be attributed to the lack of loss of Russian barrels from the market, the largest release from oil strategic stockpiles in history and the on-again/off-again status of the Iranian nuclear negotiations threatening the return of approximately one million barrels per day of lost production, most of this market dampening can be attributed to growing fears of a global recession and what that could do to demand for oil.
The recent rapid sell-off is not based in the realities of the long-term oil market. Investors are only looking at the volatility of demand, without considering the structural supply issues that will continue to plague the global oil market for at least the next five to six years. We can measure global oil inventories, the nexus of supply and demand, and see that global oil inventories will continue to fall due to a chronically undersupplied market – and this is despite China’s continued lockdown suppressing global oil demand by half a million barrels per day.
An impending recession will not result in negative oil demand, but rather a moderation on the rate of growth in the near-term. Meaning the lack of supply may improve slightly, but will still not meet overall demand, even if we factor in a recession in both Europe and North America.
With inflation in service costs, little incentive for oil producers to increase production and volatility in the oil price, it’s a safe bet that the market will remain undersupplied. Most OPEC producers are already approaching maximum productive capacity, with the UAE and Saudi Arabia adding production that won’t come online until 2025 and 2027, respectively. The US Strategic Petroleum Reserve (SPR) release is set to end in November and US shale growth is likely disappearing. China is finally showing signs of emerging from lockdown, signalling an uptick in demand. Taking all of these factors into account, our modelling points to a fundamental price of over $100 per barrel, and major analysts including Energy Aspects and Cornerstone Analytics agree.
There is a fundamental disconnect between the physical demand for oil and the financial demand for oil. Significant policy uncertainty that has arisen due to major market shifts, including an EU embargo on Russian oil in December and the prolonged Iranian negotiations, has combined with increased margin requirements, which has led to a lack of willingness to take on risk. This has led to the lowest net speculative interest in oil since early 2020, which in itself is exacerbating volatility.
So are we still bullish? Absolutely. The four major tenets of our multi-year bull market projection remain unchanged: persistent demand growth for at least the next decade, the end of US shale hyper-growth, the exhaustion of OPEC spare capacity and the end of growth from the global supermajors owing to many years of insufficient investment. With the US midterm election approaching and the end of the biggest SPR release in history, it should become much more apparent in the weekly data that the oil market remains undersupplied.
Should oil continue to fall, we would expect a production cut from OPEC, as a means of restoring balance between the physical and financial oil markets. We also expect to see further signs of Chinese restrictions easing, which will materially improve market sentiment.
Even with the rally earlier this year, energy stocks remained inexpensive and failed to even moderately account for an oil price above $100. We believe the average holding is discounting an oil price of about $50 or lower. With the average oil producer approaching “debt free” status by early 2023, their ability to increase shareholder returns in the form of dividends and buybacks may be much greater. While the drawdown may serve to shake conviction, all data points to the fact that it is only temporary. We view valuations today as extremely attractive and potential outsized returns will compensate for the additional volatility that the sector carries.
Eric Nuttall is a Senior Portfolio Manager at Ninepoint Partners, a leading Canadian alternative investment manager. He manages the Ninepoint Energy Fund and the Ninepoint Energy Income Fund.
