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How to navigate a maturing oil cycle

Norbert Ruecker/Dubai
Filed on June 19, 2021
The rebound in drilling activity is more cautious and comes in particular from private companies.

(File photo)

Crude, alongside most other commodities, is both driver and messenger of the financial market’s current hot topic — inflation


Oil at $70 per barrel. Most market observers did not guess in the midst of the crisis a year ago that oil prices will be trading above this much-watched level by mid-2021. Oil, alongside most other commodities, is both driver and messenger of the financial market’s current hot topic — inflation. The narrative is straightforward: Western world oil demand rebounds strongly and tightens supplies swiftly. In focus is the United States, where the economic recovery, propelled by stimulus, well-advanced vaccinations and a mostly concluded reopening bring a bounce in commutes and leisure activity. Gasoline is close to all-time record highs confirming the anecdotes of busy national parks and scarce rental cars. Air traffic is back above 80 per cent of pre-crisis levels mainly due to busy domestic travelling.

We believe that these demand dynamics will last. Europe seems to follow US footsteps and the economic recovery and reopening should lead to a similar albeit less pronounced rebound. The Western world accounts for the lion’s share of oil use and thus overcompensates pandemic setbacks in parts of Asia. The crisis was a projection for many fears and hopes including the one of the world settling for more sustainability and frugality. However, as things return to normal the pendulum swings back to the opposite. ‘Fomo’, or the fear of missing out, trumps flygskam. Our longing to travel and explore puts aside any climate consciousness and we seemingly have no bad feelings about flying, accurately described by the Swedish word flygskam. Oil demand should be largely back at pre-crisis levels in the second half of 2021. The recovery likely continues to deplete storage. We see oil prices moving higher by mid-year with a risk of overshooting.

There is also the supply side of the equation, which, for the past weeks, had been a source of uncertainty. Geopolitics and the prospects of Iranian exports occasionally put pressure on oil prices. Looking beyond mid-year, we believe that supply dynamics will take over as petro-nations continue to ease output restrictions and the shale business grows production. Supplies are politically and cyclically tight, not structurally. The petro-nations, under the lead of Saudi Arabia and joined by Russia, had a key role in stabilising the market last year by removing vast oil volumes. Today, these volumes are brought back to the market in a surprisingly disciplined manner. The shale business seems to return slowly to old strength. Drilling activity has ramped up past the tipping point where production moves from stagnation to growth. Prices around $70 offer a cash flow gusher. The slack in the services business tames cost inflation tendencies. That said, things feel different. The shale business seems to fear another boom-bust cycle and seems to acknowledge the climate debate. The rebound in drilling activity is more cautious and comes in particular from private companies. These supply dynamics should eventually slow and reverse the fundamental tightening. Iran’s exports might be the element to watch that shift the direction. The return of these exports seems possible this year and probable next year. From this perspective oil’s cycle looks mature and we see oil prices in 2022 rather below, in the 60s, than above today’s levels.

The past month offered a glimpse at what might become the defining element of this decade’s oil market. The net zero debate and activist investors bring new dynamics to oil’s cost curve. Some say that capital constraints will lead to underinvestment and undersupply, triggering a new super cycle. We believe that the impact on prices in the long term remains unclear. The shift towards electric mobility happens faster than anticipated and the market transitions to a no-growth period by 2025. The business becomes more cash flow financed, alongside a trend of divestment among public oil companies towards private equity, which all limits the impact of climate related capital constraints, which largely originate from western world banks. The petro-nations gain in relevance but exploiting the oil wealth in an ultimately shrinking market will require careful coordination in order not to jeopardise prices. Possibly, Opec+ is a framework of oil politics born out of the crisis that is here to stay. Time will tell.

The writer head of economics and next-generation research at Bank Julius Baer. Views expressed are his own and do not reflect the publication's policy.





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