Post quarter end, the world was once again looking at a second war unfolding as Hamas militants attacked Israel. The tragedy of this is apparent as many innocent individuals on both sides will suffer needlessly from this event. There are obviously more questions than answers at this point given the uncertainty around not only Israel’s response to this unprovoked attack but responses by governments across the globe. However, whenever these conflicts occur in the Middle East there are direct ramifications to the markets, particularly around how the markets will be affected by the impact these events have on oil supply. Obviously, oil prices will be directly impacted by whether this conflict spreads to neighboring countries and how the broader region reacts if that were to occur.

Although parallels are being drawn to the early 70’s and the Yom Kippur war, our initial belief is that we are unlikely to see a similar occurrence where significant supply was taken out of the market. However, given what we have seen in the energy space where capital investment has been less than we have seen historically, challenges do exist with oil and gas supplies. We recognize that challenges in the energy space can also have broader ramifications for other industries, the future development of renewable energy, and even regions of the world. As such, we recently asked Barrow Hanley Energy analyst, Luis Rhi, with more than 25 years of Energy industry experience, to address what is currently going on in the energy space and the potential impact on global markets.

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Q: Rising oil prices, up 30% from the lows of the summer, helped propel Energy to be the best performing sector in the 3rd quarter. While we don’t forecast future oil prices, that’s a good place to start; what do you view as driving the current rise in prices and how sustainable is that looking forward? Could we see $100 oil again?

A: It has certainly been a strong move higher for oil prices, even before the recent escalation in the Middle East. The key culprit is a very tight supply and demand for the commodity. There is simply not enough crude oil being produced relative to how much we are consuming. The Permian Basin has been the driver of global growth over the last 18 months but offset by Saudi Arabia taking 1 million barrels offline. Demand has been improving post-COVID in the U.S. and around the world, absorbing all the spare capacity and then some. Are prices sustainable? We think they are given these are long-term problems and not easily fixed in the short-term given the lack of spare production capacity that could be brought to the market.

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Q: Geopolitics have always been impactful, and the current environment is no different. How do you think about the long-term supply impact from potential shocks?

A: While it’s hard to handicap potential outcomes, there are several conflicts occurring that have the potential to deliver material shocks to supply, demand, or both. Expansion of conflicts to oil-producing regions near Israel or Turkey and the on-going Russia-Ukraine hostilities could all have spillover effects. However, the more observable geopolitical impact to supply is from countries like Saudi Arabia using oil revenue to fund social spending, which is becoming increasingly expensive. These countries need higher prices to afford their domestic programs, and with rising costs to produce, it means that prices are likely to stay higher as they manage their production levels to keep the market in balance.

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Q: Speaking of investment, companies have clearly seen investors reward capital discipline, including prioritizing returning cash versus reinvestment. Regulatory and environmental concerns have also impacted the incentive to drill. Are energy prices likely to be structurally higher for the long-term due to this underinvestment?

A: Short answer—yes. This underinvestment over the last several years will take a long time to unwind. Rig counts in the U.S. are down more than 25% from recent peaks. They will need to increase from these levels to even maintain the current level of production in America going forward. As those rigs come online, it will be more expensive to drill as well. Adding in the pressures from higher interest rates, the cost of capital is increasing significantly for energy companies. Hurdle rates for drilling new wells are only going higher, not to mention the pressures from investors and environmental regulations, government and otherwise. All in, companies are being rewarded for returning cash and this will continue to be a key part of the long-term bullish story on oil prices.

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Q: Turning to demand, most of the world has reopened at this point. How do you see demand trending from here and are there any countries or regions, perhaps China, that may have more recovery to go? What about the offset from the energy transition we hear so much about in the media?

A: The largest driver of demand growth remains the Emerging Markets. Developed areas are continuing to hold steady in terms of overall demand, but places with population growth such as the Middle East, India, Southeast Asia, and more are all seeing the largest increases. The big wild card remains China—where demand is improving but a potential shift away from manufacturing to other industries could lessen future growth. While there’s much discussion regarding energy transition and the rise of electric vehicles, we are still many, many years away from a material impact to demand. Those optimistic outlooks continue to get pushed out, and while they may come to fruition in the following decade or two, the interim period will continue to see annual demand growth of hydrocarbons approximate 30-50% of global GDP growth. We have already exceeded pre-COVID 2019 demand levels and will likely continue to grow from here.

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Q: Thank you for the insights and explanation of the current state of the global energy markets. Any parting thoughts to share?

A: One last interesting point to make is on the stocks and sector itself. When looking at the MSCI World Index, the number of stocks classified as Energy has fallen from 115 companies a decade ago to just 57 currently and stands at just 5.2% of the overall MSCI World Index—a decline of nearly 50% over the prior decade (chart below). Much like the underinvestment in production, there has been a broad decline in investment by investors in the space as well. This represents a classic “value” opportunity given the combination of cyclical and secular drivers laid out above.

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Important Information:

Past performance is not indicative of future results.

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