What’s really driving oil prices higher?

Author: Steve Bonnyman

May 16, 2018

The recent run up in oil prices has caught the attention of investors, with WTI up 50% from only a year ago and holding at around three-and-a-half year highs. While the rally itself is unquestionable, reasons for it, and whether these levels are sustainable are more widely debated.

We believe there is a larger, secular issue at play that is driving up prices. The recent run we have seen in energy has been fundamentally driven as a result rising demand, restrained supply growth and the subsequent inventory drawdowns (as opposed to a speculative rally in any sense).

Evidence of inventory constraint can be found in the “days of cover” measure. This indicator, which illustrates the number of days that inventory on hand would cover current demand, has fallen to decade lows of 54 days, from around a long-term average of 60 days, and well below the ranges seen of the last five years.

Source: Cornerstone Macro Research, May 2018

While it is easy to invoke the OPEC cuts as the primary source of supply constraint, the issue is much broader based, with production from Venezuela collapsing, and volatile production profiles from Libya and other geopolitically fragile nations.

Additionally, the market is now facing the U.S.’ withdrawal from the Iran nuclear deal. While this will certainly impact prices to a degree (we estimate real constrains of roughly 400,000 barrels per day of Iranian production coming off the market, if not more), Iran only accounts for a small fraction of global oil production currently.

Even the regions of production growth are facing challenges in bringing oil to market. The U.S., and specifically the Midland region of Texas, is one of the few locations globally reporting meaningful growth in oil production. Differentials in this region, or the difference in pricing between the Midland basin and getting oil to a major hub (Cushing) have recently gapped out – where differentials measured zero only a year ago, this indicator has now grown to $12 per barrel. Recognizing that the only global source of meaningful production growth is unable to efficiently get oil to the market, this is a clear signal to us that the market is supply constrained and will be for some time.

Source: Cornerstone Macro Research, May 2018

So what does this mean for investors? Higher oil prices stemming from longer-term fundamentals, as opposed to passing geopolitical risk, suggests that prices should remain elevated for some time, in our view. Complicating matters however, particularly for North American producers, is increased doubt that higher prices will directly equate to new oil investment due to pipeline capacity uncertainty out of key basins.

In any event, higher oil prices are generally a net-positive for the Canadian economy, which should be supportive of Canadian equities. With domestic energy stocks having a lot of room to catch up to the underlying commodity, the sector could be well positioned to rally in the coming months.

 

 

Commentaries contained herein are provided as a general source of information based on information available as of May 14, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.
AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), Highstreet Asset Management Inc. (Highstreet), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI and Highstreet are registered as portfolio managers across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

Written by

Steve Bonnyman, MBA, CFA

Co-Head of North American Research and Portfolio Manager

AGF Investments Inc.

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