Oil Price Weakness, A Chance for Energy Investors

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  • Energy investors are being tested once again.
  • The price of oil has plunged by 15 per cent, suffering its longest stretch of sequential declines since 2019.

A recent news article published in the Financial Post written by Eric Nutall states that energy investors need to rise above fear and see oil price weakness as a gift.

Energy stocks have sharply fallen

Energy stocks have sharply fallen, with some down as much as 25 per cent in a few weeks.

Headlines about potentially faltering oil demand due to a rise in Delta variant cases abound, but does the fear of demand destruction really account for the plunge in oil or are there other factors at play?

Do energy stocks have more downside ahead or has the worst-case scenario (and then some) already been priced in? Is the past month a mere speed bump or has something fundamental changed that derails my call that oil is in a multi-year bull market?

Virus reduces oil demand

The memory of 2020 is still fresh in investors’ minds. Out of nowhere, a virus emerged that temporarily reduced oil demand by the greatest amount in history by several orders of magnitude.

The velocity and quantity of the hit was shocking, as was the collapse in energy stocks, with some plunging by as much as 90 per cent, devastating energy investors and their desire to ever invest in the sector again.

Fourth wave in Canada and Delta variant cases

Now, with the fourth wave in Canada and Delta variant cases rising around the world, the energy market is grappling with how oil demand will be affected this time around.

Marrying these fears with poor summer trading liquidity, changes in the United States Federal Reserve’s tapering expectations and a commensurate rally in the U.S. dollar, some softening economic data points, and a general risk-off environment, one can partially appreciate why oil has weakened.

The job of investors, however, is to see the world as it is, not worse than it is due to fear, or better than it is because of greed, and then invest accordingly.

It would be natural to worry about a potential drop in oil demand due to rising case counts, but what does the demand environment actually look like and what tools can you use to evaluate it?

Enormous volatility of the energy sector

My compass in navigating the enormous volatility of the energy sector is to measure changes in global oil inventories, which are the nexus of supply and demand and provide an effective way to measure the oil market’s oversupply or undersupply position.

Using data from companies such as Kpler, which leverages satellite imagery with artificial intelligence, one can measure global inventories in almost real time.

Latest Kpler data

What does the latest Kpler data tell us? At the beginning of this year, the surplus oil held in inventories relative to the 2017-2019 average sat at 220 million barrels.

Due to normalizing demand, modest U.S. shale growth and restrained Organization of the Petroleum Exporting Countries production, that glut has fallen by three-quarters to 56 million barrels.

What does the oil price collapse imply?

Importantly, the pace of inventory declines has not changed in recent weeks, suggesting that the degree of demand destruction is a fraction of what the fear-mongering headlines would suggest.

If demand had suddenly imploded, and the oil price collapse implies a decline of four million barrels per day, it would show up in rising inventory levels.

The opposite trend is visible today. If the oil price collapse cannot be fundamentally explained, then what other factors could be at play?

A critical distinction that energy investors must make is the difference between the physical market for oil versus the financial market for it.

The physical market for oil is the world’s largest commodity market, valued at roughly US$2.2 trillion per year, while the financial market for oil is roughly 30 times larger, according to Cornerstone Analytics.

Financialization of oil

The financialization of oil has resulted in it being used in a variety of ways other than an outright call on oil supply and demand, such as oil contracts being used as an inflationary hedge.

As inflation expectations have recently softened due to signals of potential Fed tightening, the net speculative length in crude oil contracts has fallen.

Thus, the financial demand for oil has temporarily imploded while the physical market for oil shows few signs of declines.

Ultimately, the physical market wins and is directed by fundamentals, so what does the landscape look like today?

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Source :Financial Post

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