Oil Market Could Remain Tight Without Investments

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Daniel Greenspan, CIBC Asset Management, senior analyst and resource team director. The recent moves in the oil price have been volatile to say the least. There are a lot of geopolitical and macro factors at play that are having dramatic impacts on the market. So far this year, oil has moved from a low of $76 a barrel in January to a peak of $124 in early March, before falling back to $110 in mid-June. A number of supply and demand factors are exerting forces on the market that are pushing and pulling the price day to day and week to week.

On the supply side, critical near to medium-term factors that we’re watching include the war in Ukraine and the sanctions on Russia, the OPEC Plus supply response, and the North American supply response to higher prices. On the demand side, we’re closely watching COVID lockdowns in China, and the impact on growth and demand from higher interest rates around the world.

Starting with supply, clearly Russia is a critical source of oil to the global market, accounting for around 10% of global supply. Our view is that sanctions likely remain in place for the medium term, even if there, hopefully, is a near-term resolution to the conflict. In the short term, we expect most Russian barrels will continue to find a home in the global market, albeit at a large discount. But ultimately, we think that the ongoing sanctions will materially curtail supply from the country over the medium term. Looking at OPEC Plus and its supply response, we note that very few members of OPEC have actually remaining spare capacity to bring to the market. There’s been limited investment in recent years in adding capacity. And once OPEC is back to full production levels over the next couple months, there’s little more production it can bring without making material investments in growth. Closer to home, we continue to see limited appetite for North American suppliers to add volume to the market. The theme of capital returns to shareholders rather than investing for growth remains firmly in place.

Key near-term risks we’re watching for energy include easing the Russian sanctions, which we view as a low likelihood event, more supply than expected coming from North America or OPEC, demand destruction at higher prices, or demand pulling back on COVID lockdowns in China specifically.

As for the medium to longer-term outlook, our view is that without a shift to more of a growth mindset from producers and an investment in new capacity, the oil market will remain tightened over the medium term. We’ve seen very limited investment in growth over the past number of years, and that narrative is not yet shifting. Really, producers are in a tricky spot. Access to capital isn’t the same as it’s been in the previous cycle and producers will have to live more within their means, funding growth from cashflows and operations. On the demand side, with travel restrictions easing around the world, we expect demands to remain reasonable, which could serve to keep the oil markets tight.

Looking out in the longer term, the transition to a lower-carbon economy is inevitable and will ultimately be a long-term headwind to oil. The timing of this transition is wide open to debate and will depend on numerous factors that are not yet clear. These factors include government policy, consumer patterns, binding of critical minerals, infrastructure upgrades, and developments of new technology. Our general view is that the transition to green energy will be challenging and somewhat longer dated than current government set targets would suggest.

In terms of our equity view, we still favor upstream producers over midstream companies, and think that larger cap energy names still offer good value at current levels. Our top pick is Cenovus, which we view as an intersection of quality and value. Company is delivering on the asset base, on the Husky integration, and on the capital allocation strategy. We see potential for further optimization of operations, ongoing balance sheet strength, and further capital returns that can continue to drive the stock to outperformance. We believe the stock is undervalued at current levels and see upside potential as the company continues to deliver on key milestones. We still see significant dividend growth potential from the company compared to peers.

Another name in the Canadian sector that we like is Suncor. Suncor has struggled to maintain investor confidence in recent years as a series of operational missteps and questionable capital allocation decisions have impacted operations and its reputation. Recent investor activism in the stock has been well received, and we’re hopeful the company is constructively engaging to make meaningful and lasting changes that improve operational performance in the coming quarters.

We do see potential for Suncor to deliver on key operations and regain its leadership position in the Canadian energy sector. The company completed a number of turnarounds of its assets, appears to be finally on a constructive path forward of its key asset Fort Hills, and is taking control of Syncrude. These actions taken together give Suncor the opportunity to deliver on operations, regain investor confidence in the story, and drive multiple expansion in the stock. Right now, we see value in Suncor at the current share price.