Eric Nuttall How strong oil demand will keep prices above US$100 a barrel despite recession fears
Fears of a recession are dominating the market, raising questions around the potential impact on oil demand and inventory, and ultimately, its price. There’s been a dramatic sell-off of energy stocks recently – in fact, the worst sell-off since March 2020, according to Bloomberg LLP. So, it’s understandable that investors have fears about a correction with such elevated price levels. But this isn’t cyclical – it’s a structural bull market.
If there’s a recession, oil prices will move down slightly, but the supply versus demand gap is so large that it’s unlikely that prices will go below US$90 a barrel, or, at best, US$80. It won’t hit the lows seen in the past cycle.
The U.S. Federal Reserve Board’s moves to raise interest rates would likely be countered by the very strong U.S. labour market. And although consumer spending is dipping, gasoline demand is still robust and U.S. employment is still the biggest driver of gasoline demand.
Historical data indicate that large increases in retail gasoline prices over the next 18 months could lead to a further 2 per cent decline in demand for gasoline, according to research firm Energy Aspects. At the same time, the increase in employment over the past decade points to a 4.2 per cent increase in gasoline demand. Taking both factors into account leads to the likelihood that declines in gasoline demand will be moderate.
There is also still significant pent-up demand from the past two years, resulting in rising gas prices being absorbed more easily. One of the measures to consider is the U.S. household debt-to-service ratio. When compared with 2008-09, the current ratio is very small, especially for the bottom 90 per cent of the economy. In 2008, the ratio was well above 13 per cent, according to U.S. Federal Reserve. It’s about 9.5 percent now, so the current debt burden is much lower.
Mortgages tend to be a household’s biggest liability, accounting for two-thirds of all debt. But interest rates on mortgages are most often fixed, which means that even a sustained increase in market rates will not likely move the debt-to-service ratio much above 10 per cent. This momentum doesn’t mean that there won’t be pain – particularly in the lower income levels. But there’s still strong growth in the mid-to-high income levels, which will keep the economy moving.
The Asia factor
The biggest impact on gasoline demand is the strong recovery in Asia. In Indonesia, demand this summer soared to 40 per cent above 2019 levels, according to Google LLC mobility data. Thailand, South Korea and even Japan, structurally a declining economy, have seen gasoline demand rise back up to pre-COVID-19 levels thanks to stimulus including reductions in taxes or subsidies. And China is just starting to re-open its economy after recent lockdowns.
Even factoring in a mild recession for the U.S. next year and a fairly deep one for Europe, we estimate that global demand for oil is growing by 900,000 barrels a day, year over year – and this is a very conservative estimate. Although European demand will likely decline by 500,000 barrels a day and the U.S. by more than 100,000 barrels a day, growth in Asia will more than make up the difference.
The year-over-year growth in China could be enormous. Although Chinese demand was down by more than a million barrels a day in April and May this year, by October we expect President Xi Jinping to start to ease more of the zero-COVID-19 measures after the 20th Party Congress that will bring workers back to the factories and further drive demand.
Can inventories and capacity meet demand?
This very strong growth out of Asia will have to be met by inventories – and there really aren’t large enough inventories, especially with lost Russian production. Even though the drop in Russian production wasn’t as steep as initially expected, other unplanned outages, such as Libya, have kept inventories tight. Saudi Arabian exports have also been flat for the past six months and indicate a lack of spare capacity.
Demand would need to go down by three to five million barrels a day to balance the market on a structural basis in the medium term. That’s very unlikely given that oil demand has only declined four times since the 1970s, including COVID-19 and the 2008 global financial crisis, according to the BP Statistical Review of World Energy. Demand for oil has repeatedly proved to be very inelastic.
This strong outlook for demand will likely keep Brent Crude and West Texas Intermediate oil prices above US$100 a barrel into 2026, sustained in part by oil producers having underinvested in capacity.
Global energy companies are currently investing about US$400-billion into sustaining production, according to Energy Aspects estimates. To hold production flat at 100,000 barrels a day, we need a minimum of US$550-billion in investment, much of which will be absorbed by cost inflation. So, the shortfall is about 30 per cent.
Investment plagued by ESG as usage rises
This chronic underinvestment has been occurring for more than eight years, first driven by shale producers driving down the back end of the curve, followed by environmental, social and governance (ESG) mandates curtailing spending.
Worse still, even at US$100 oil, no producer is jumping up to invest, so there’s no flood of oil in the medium term either.
This is a structural issue. Even in the U.S., producers are not adding wells. They can’t find people, waiting times for steel pipes for wells have gone from 10 to 180 days, and chief executive officers’ remuneration now includes ESG metrics rather than just production growth.
But global energy usage continues to rise while developed economies pull away from fossil fuels. There is not nearly enough investment in alternative energy solutions. The national oil companies are starting to do more, but it won’t be until 2027 that some of the bigger projects are online and, in that time, demand will continue to grow, keeping prices strong.
What does that mean for the Canadian energy sector? These sustained strong oil prices will result in record cash flow for Canadian energy companies, especially those companies that were able to pay down debt aggressively in the past two years.
Given the depressed share valuations, it’s likely that these companies will prioritize using this free cash flow to buy back shares and increase their dividends over meaningfully increasing production. Therefore, they will be rewarding shareholders for enduring the worst bear market in history, while also helping to drive a rerating in share price trading multiples.
Amrita Sen is co-founder and director of research at Energy Aspects Ltd. in London, England. Eric Nuttall is a partner at Ninepoint Partners LP and senior portfolio manager of Ninepoint Energy Fund and Ninepoint Energy Income Fund in Toronto.