Andrii Yalanskyi
Oil prices have pulled back from recent highs as demand concerns and increasing recession fears take center stage in global markets. Greg Bonnell speaks with Daniel Ghali, Senior Commodity Strategist at TD Securities, about why crude prices don’t reflect current supply and demand challenges.
Transcript
Greg Bonnell [00:00:03] All these recession fears have sparked a major outflow from commodities funds, and that’s pushed crude off of its recent highs. But our next guest says that price action isn’t reflecting the true supply demand dynamics in the sector. Joining us now is Daniel Ghali, senior commodities strategist at TD Securities. Daniel, welcome to the show. Great topic. Let’s dig right into it cause people are trying to figure this out. What does a possible recession mean for crude and what’s really going on in the markets? What is really going on?
Daniel Ghali [00:00:29] Yeah, absolutely. And listen, thanks for having me on. I think over the last week, what we’ve seen is the steepest commodity outflows since 2014. That statement on its own is actually really significant because what it says is that the pace of outflows from broad commodity funds over the last week was actually steeper than observed during the COVID 19 panic. What’s driving that? Well, certainly recession fears have been top of mind for most money managers, and I think that that’s primarily the reason why we’ve seen this. What it’s concealing, however, is that behind the scenes, the physical markets have actually tightened and they’ve sent a strong signal that brent crude, for instance, in physical markets is actually scarcer today than it was a week ago. This is really a dichotomy between what the futures markets are signaling and the physical markets. From a fundamentalist perspective, really, nothing has changed. We see severe constraints to oil production over the next year or so in the US after all the shale patches printing money. And certainly that means that the incentive to reinvest that cash windfall into operations is at its highest levels in more than a decade. However, we’re seeing capital expenditure expectations rise only modestly. And in fact, when you account for inflation, they’ve only risen to such an extent that you’d expect the rate of production growth to remain stable or at similar levels that it is today. Well, where else can we get more oil out in the world? Let’s talk about OPEC. OPEC has been under producing on a sustained basis for the last year. That’s a result of a decade long period of under or under-investment into the energy infrastructure that is coming home to roost today. We know several nations within OPEC are having operational constraints, but geopolitics have also been a major barrier to increasing oil production. Not only with respect to Russia, which we’ll get to in just a little bit, but several nations, including Iran, which of course the world is looking towards the Iranian nuclear deal as a potential avenue to increase oil production. But other countries, such as Libya, have been struggling amid a political crisis, and that’s constrained the amount of oil that we can get out there.
Greg Bonnell [00:02:49] That’s interesting, right? Because people, I guess, in traditional times or even through the pandemic would say, listen, if we were actually going to get into a situation where demand is outstripping supply, then we looked at the OPEC meetings and we say, oh, they’re going to boost production, so we’re going to be fine. But there’s been a lot of question marks as to their actual capabilities. If we do need significantly more to meet demand if we even meet that demand.
Daniel Ghali [00:03:10] Yeah, absolutely. I mean, that the pace of production today, we’re really running at the lowest spare capacity levels that we’ve seen in a very long time. What that says is any oil shock is going to be really hard to absorb. So even if you’re looking towards a recession in the next year to bring down the pace of oil demand growth and therefore to balance markets in that way, well, looking historically, there’s really only been four periods of time in which the oil demand growth has been negative on a year on year basis. That’s the OPEC embargo in the early 1970s, the Iranian revolution, and also in the seventies, the global financial crisis and COVID 19. Outside of those extraordinary instances, every other recession has only translated into a slowdown in demand growth. But yet what that means, and that is a critical caveat, I’d say, is that we’re still going to be eroding what little is remaining of the world’s spare capacity. And the big picture here is that that means supply risk is going to remain in oil markets over the next year.
Greg Bonnell [00:04:17] Given that, why aren’t we seeing the investment into future production? Are these just timelines that companies don’t want to commit to if they think that we’re moving to a future where we’re not as reliant on carbon and they say, wait a minute, this these are big investments. We just don’t want to make them?
Daniel Ghali [00:04:33] I don’t think that’s the case. I think, you know, ESG has been a major driver of the decline in capital expenditures in the shale patch, but also abroad and globally. What we’ve seen is that sectors that have a higher carbon intensity tend to be associated with lower reinvestment ratios. And so what that tells us, it’s really the ESG theme that is driving the higher cost of capital for reinvesting into your operations when you’re in a capital or carbon intensive industry and also say that right now we’re in a period of time where the supply chain in the energy sector is also constraining the ability for firms to increase their production. In the US, of course it’s private firms and so there is clearly incentivized to raise their production growth. But we think that labor is scarce, equipment is scarce, and historically you’ve been able to cannibalize some spare parts from prior operations. But today that’s been done and the supply chain disruptions are inhibiting their ability to grow production as well.
Greg Bonnell [00:05:40] It seems like we’re leading to a discussion maybe about the refining part of the energy space, right. It’s one thing to say of the production, to get the crude, to find the crude, to get it out of the ground. But refining capacity, it takes the humans. It takes the infrastructure. Are we keeping up on that front either I mean, new refineries, you know are very expensive propositions?
Daniel Ghali [00:05:58] Right, absolutely not. And that is one area where the long term demand destruction that people expect in oil is constraining the amount of money that’s going into the refining sector.
Greg Bonnell [00:06:08] What does this mean for the price of oil going forward? I mean, obviously, we’ve been on quite a wild ride so far this year. And then as it flows down to the average person, even beyond, like, you know, our scope as investors, we feel it when we fill up the cars, when we pay our energy bills. Where do you think we might be headed in all this?
Daniel Ghali [00:06:22] Well, I think the point here is that supply risk is going to continue to remain embedded in crude oil prices. And so while you typically expect in a recession, crude oil prices tend to decline by 50 or even 75%, this time around, it won’t be anywhere near that. And so we’re going to see oil prices remain elevated for the foreseeable future.
Greg Bonnell [00:06:40] You talked to off the top about the disconnect that we’re seeing between the futures market in terms of, you know, telling us about perhaps demand for crude going forward and the actual physical market. Is there ever going to be a situation where we can sort of bridge that disconnect between what the futures are telling us, what the physical market is? Always a bit of friction there.
Daniel Ghali [00:06:58] No, absolutely. I think those kinds of disconnects don’t occur for a very long period of time. And so we do expect the futures market to reprice in line with what the physical markets are saying. The reason that the futures markets are disconnected are the extremely steep outflows that we’ve seen from broad commodity funds. And so if you’re familiar with those, they hold a basket of commodities. And as the money managers holding these funds are concerned about a recession, they’re pulling their capital out. What that translates to is indiscriminate selling across all commodities. And so that’s why there may have been a mispricing here.
Greg Bonnell [00:07:33] It’s awful hard to tie markets at all. You’re saying you’ve seen these huge outflows. Are there any signs you’re looking for a stable stabilization in that place? Sort of. I think we’re all just sort of looking for some sort of indications, whether it’s the commodities markets, the equity markets, of some sense of, have things calmed down, are they going to stay calm or are we still in for a rocky ride?
Daniel Ghali [00:07:53] I think we’re still in for a rocky ride here. I mean, the fact of the matter is that spare capacity is extremely low and that what that means is that any shock is going to be really hard to absorb. But we’re also in a period of time where the likelihood of a shock is extremely elevated. We know that high energy prices, a high US dollar and a Fed that’s hiking tend to be associated with unrest in the emerging market world. And so emerging market producer nations might start to face some unrest next year that might inhibit their ability to produce oil, and that’s one potential source of supply shock on the horizon.
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