Demand is Not the Whole Picture for the Oil Price

Earlier this month the International Energy Agency published new forecasts for oil demand growth for 2024 and 2025, reflecting a softer demand environment – growth of 1.2 million barrels per day (mbpd) and 1.1 mbpd for 2024 and 2025 respectively, compared to an average of 1.3 mbpd in the decade prior to Covid. Slowing demand is not new news, and this is not another piece discussing energy transition. Rather, the publication of the IEA’s forecasts was a reminder that demand is not the whole picture for the oil price. It pays to look into the supply side, where there is a highly bifurcated picture between the US at peak production, and OPEC showing unusual supply discipline and with material excess capacity.

Over the last two years, Department for Energy data show that supply has grown approximately 15% less than demand (Chart below). The US, Canada and OPEC together account for approximately 50% of global production – 18 mbpd and 27 mbpd respectively for the US/Cananda combined, and OPEC respectively.

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Since March 2022, production in the US and Canada has grown by 1.78 mbpd, offset perfectly by OPEC, shrinking by 1.83 mbpd (chart below). OPEC’s supply discipline is notable given that it is occurring against Russia’s incentive to act independently to maximise production. In other words, OPEC is holding firm despite a partner free-riding.

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OPEC unity may, of course, not survive geopolitical tension in the middle east. But if it does, it will have important consequences in terms of higher-for-longer oil prices, because long-run production growth is heavily dependent on OPEC reserves and resources. Data from Rystad Energy show that proven and probable reserves are overwhelmingly in OPEC and non-OECD countries. It’s reasonable to expect that we will see higher lows and higher highs in crude prices in coming years despite slowing demand, and that oil exporting countries will enjoy a continuing boom even as the world accelerates along the path towards lower crude consumption.

For public companies today, there is still limited appetite for capex, which means that despite the strong price returns for the whole sector over the last two years, free cash flow yields continue to look attractive.

Don’t Write Off Clean Energy Stocks Yet

It’s not been a great start to the year for clean energy stocks. The iShares Global Clean Energy ETF is down about 10% so far while fossil fuel stocks have surged largely driven by an over 15% oil price increase amid geopolitical tensions and supply concerns.

Clean energy stocks have been unloved for some time as the industry grapples with cyclical headwinds such as higher interest rates, input cost inflation and an increase in project complexity – and not to mention political attacks. A net $13 billion was pulled last year from US-based sustainable funds due to disappointing investment performance and heightened political scrutiny, according to Morningstar Inc.¹ The research firm said 2023 was the first calendar year of outflows for US sustainable funds since it started tracking the sector 10 years ago.

However, when looking at global investment in fossil fuels vs clean energy (Figure 3) we can see that annual investment in clean energy has significantly outpaced capex into fossil fuels over the past few years; much of this from tax breaks and government subsidies that are accretive to the bottom line. This is significant and suggests cyclical trends and the supply/demand dynamics of fossil fuel companies should not distract from the long-term potential of renewables.

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The biggest contributor is the Inflation Reduction Act (‘IRA’) in the US which contains $370 billion in energy and climate incentives, directing more spending towards environmental concerns than any other single area. We believe the most important allocations are the investment tax credit of 30% for renewable projects, the production tax credit of 1.5c/kWh for firms producing renewable power and the extension of existing subsidies and credit for either ten years or until emissions targets are met. This latter feature is notable: the ten-year extension allows for far more certainty for businesses and investors, supporting the case for renewables as an attractive, longer-term investment.

But is the IRA at risk? We won’t attempt to make any call on what may happen to these projects after the US elections in November but it’s worth pointing to Bloomberg research² that shows Republican states stand to benefit significantly more than Democratic ones from the Act. Red states are set to attract $337 billion in investments for renewable projects through the end of the decade versus about $183 billion earmarked for Democratic regions.

While the EU’s Green Deal does not have the same monetary clout, it does act as a tailwind for investment into renewables outside of the US. The act aims ensure that by 2030 EU manufacturing capacity is sufficient to meet 40% of its equipment needs for solar or wind power, batteries, heat pumps, electrolysers and fuel cells, biogas or carbon capture.

Though we are not claiming fossil fuels have had their run, investors should not disregard renewables given their recent underperformance. The long-term case for renewables should continue to mount as governments continue to seek to mitigate climate-related risks and proceed towards their net zero goals. Thus, the disconnect between real-world capital investment and stock performance could present an investment opportunity. Similarly, the downward trending price/earnings ratio of the Goldman Sachs global renewables basket³ (Figure 4) implies that renewables may be relatively ‘cheap’ and attractive.

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With contributions from Ed Cole, Managing Director, Head of Multi Strategy Equities, Solutions; Jessica Henry, Responsible Investment Specialist and Rob Furdak, CIO for Responsible Investment, Man Group.

1. www.morningstar.com/sustainable-investing/us-sustainable-funds-register-first-annual-outflows-2023
2. www.bloomberg.com/graphics/2023-red-states-will-reap-the-biggest-rewards-from-biden-s-climate-package/?embedded-checkout=true
3. The GS Global Renewables basket consists of US, Europe and Asia stocks that stand to benefit from a transition towards the use of cleaner energy. The basket is diversified across industry verticals. The basket is modified liquidity weight with no name greater than 2.7% and rebalanced quarterly.