Overall, this suggests risk to energy prices in the near-term remains to the upside, Nonetheless, it is worth considering potential rise in supply from other sources.
Chief Market Strategist, Asia Pacific
- Geopolitical tension in Europe, strong demand recovery and weak supply growth are all contributing to higher oil prices
- Possible Iran nuclear deal and fresh investment in U.S. oil production could provide some relief
- Energy and raw materials could remain as an investment bright spot for now amid Fed’s hawkish stance
Oil prices have defied the recent market correction and maintained their upward momentum. Brent crude breached above $95 per barrel (pb), the highest since 2014. The ongoing economic recovery, low inventory and the escalating geopolitical tension between Russia and Ukraine are driving recent price action. Higher energy prices could fuel market concerns over elevated inflation and put developed market central banks in a dilemma. In addition to be a catalyst to higher costs, more expensive oil prices are a tax on households’ disposable income and hurt consumption. That said, it is worth noting that there are some additional developments in the energy sector that could help to contain price rise.
The threat of Russia launching a military attack on Ukraine is at the forefront of investors’ concern right now. The Biden administration has already warned Moscow of severe economic sanctions if Russia invades Ukraine, and this is echoed by its European allies. Russia’s exports of oil and natural gas makes up about 8.4% and 6.2% of global production, respectively. It is the largest supplier of crude oil to the EU, making up 27% of the union’s imports.
Economic sanctions against Russia could squeeze global oil supply and exacerbate the oil inventory destocking seen in the past two years. This could come at an inconvenient time when the global demand is recovering as COVID restrictions are relaxed. The International Energy Agency projects global oil demand to rise by 3.2mn barrels per day (mb/d), or 3% of 2021 demand. While OPEC has pledged to increase output by 400,000 barrels per month, the cartel’s progress has fallen short of its target and therefore failing to sooth upward price pressure.
Exhibit 1: GLOBAL OIL SUPPLY AND DEMAND
Million barrels / day
Overall, this suggests risk to energy prices in the near-term remains to the upside, Nonetheless, it is worth considering potential rise in supply from other sources. U.S. oil production is set to expand with oil rig count picking up. According to the U.S. EIA, the number of crude oil rotary rigs has risen from 260 in December 2020 to 475 in December 2021, and energy companies are continuing to invest in new rigs. This could potentially add another 0.8 to 0.9mb/d by the end of 2022.
Another possible relief to oil supply could come from breakthroughs in the Iran nuclear deal. Iran, the U.S., China, Germany, France, UK and Russia are sending delegates to Vienna this week to continue with negotiation that could see economic sanctions lifted in exchange of Iran curbing its nuclear program.
While U.S. oil production growth and potential breakthrough in the Iran nuclear deal could provide some relief to the oil market, the underlying demand and supply dynamics should still support energy prices at least for the first half of 2022. A further escalation of tension in Europe would bring a sharp spike in energy and broader commodity prices.
Higher energy costs would benefit energy and commodity sectors in the near term. This is particularly important as the broader equity market is re-assessing monetary policy outlook by the U.S. Federal Reserve and other developed market central banks. Not only the Fed could opt for a faster pace in raising interest rates, the peak of the upcoming policy rate hiking cycle could also be higher than expected. Higher yields could create a greater divergence in performance in value and growth sectors. Higher energy costs could also act as a catalyst for governments to invest more in renewable energy and reduce their dependence on fossil fuels.
For fixed income, the energy sector in the corporate high yield market has already outperformed in 2021, but high energy prices could provide more room for spread compression (U.S. HY energy sector spread to worst was 431bps vs 424bps for the benchmark), adding to potential total return.