5 Reasons to Expect Higher Oil Prices

Neil Dwane | 30/05/2017
Oil field

Summary

Despite a recent bout with plunging prices, we believe the oil market should grind higher thanks to solid global demand, renewed supply constraints and still-significant underinvestment. This builds a clear case for investing in the energy sector, both for income and for capital return.

Key takeaways

  • Investors should expect to see higher oil prices in the medium to long term as inventories are reduced.
  • Among the primary reasons for higher prices: Major oil producers just agreed to extend production cuts, in part because many petro-states are growing more fragile; improving global growth should boost demand; and new oil discoveries have become increasingly rare.
  • Higher prices are good for energy investors but have a downside: They can push inflation higher and act as a tax on economic activity.
  • Investing in the energy sector still offers both attractive equity income and capital return opportunities, but risk management is paramount.

Why we're constructive on oil

Not many investors have been bullish on the price of oil recently, but Allianz Global Investors has had a constructive view of the industry for the past 12-18 months. Now that both members and non-members of the Organization of the Petroleum Exporting Countries (OPEC) have renewed their commitment to limit production in an attempt to boost prices, it's a good time to review the prospects for oil. Here are five reasons why we think the price of oil will turn around – and why investors should consider positioning themselves to take advantage of the opportunity.

1. Global demand for oil is reassuringly stable

Although the International Energy Agency (IEA) lowered its predictions for oil-demand growth in 2017 from 1.4 million barrels per day to 1.3 million, global demand has remained reassuringly stable. At the end of 2016, the world consumed slightly more than 97 million barrels per day, making the IEA's modest downward revision look relatively inconsequential and still representative of healthy growth. At the same time, oil inventories have been decreasing and global economic growth is buoyant. Taken together, these factors should underpin a steady demand for oil despite higher prices.

It is important to note that a rising oil price has a downside as well, given that it functions as a tax on consumers and the global economy in general. Higher prices may crimp consumer spending and drive inflation through the economy. This effect can be amplified by currency movements globally, particularly given that oil is often priced in US dollars. For example, the post-Brexit fall in the British pound had the effect of re-pricing oil to the equivalent of USD 70 per barrel by the time it reached consumers at the pump.

 

Energy production growth is slowing
Percentage of energy production (million tonnes of oil equivalent) growth per decade

Oil chart

Source: International Energy Agency as at 31/12/2015.

2. Multiple factors will constrain the oil supply

Global supply levels became much more difficult to assess in November 2016, when members and non-members of OPEC agreed to reduce production as a way to drain the oversupply of oil and boost prices. On 25 May, this agreement was extended through March 2018. While analysing the actual effectiveness of this agreement will continue to be challenging, there is little doubt that it has improved the supply/demand balance.

Moreover, many OPEC nations are effectively petro-states that derive most of their government financing through the taxation of oil and gas revenue. When the price of oil is threatened, their institutions become vulnerable – and given that oil prices have been low for some time, many of these countries have experienced serious issues:

  • Mexico, already under pressure from the trade and immigration policies of US President Donald Trump, has seen its revenues and financial flexibility drop sharply as production and profits fall.
  • Venezuela, which produces around two million barrels of oil per day, has struggled with hyperinflation and appears on the verge of collapse as its economy runs out of cash, credit and food.
  • Nigeria is suffering not only from a weak, inflation-prone currency and economy, but from serious security problems in its oil-producing delta regions.
  • Oil production across the Middle East is also being threatened by continuing destabilization in countries such as Libya and Iraq – which may get worse before it gets better.

The fragile state of many petro-states is one of the reasons why OPEC is aiming to boost prices by cutting production. These issues have also ratcheted up geopolitical tensions – already at an elevated level thanks to US airstrikes on Syria and missile testing in North Korea. If markets become increasingly nervous, we expect to see a further premium on prices.

 

The supply/demand imbalance may be shifting
World oil supply/demand in millions of barrels per day

Oil chart supply demand
Source: International Energy Agency as at 31/12/2016.

3. New discoveries are dwindling

For decades now, discovering new oil fields has grown increasingly difficult. As a result, the global economy is essentially relying on a few old and ageing mega-fields to produce the supply of oil it needs. In fact, aside from the US shale-oil industry, which has made significant advances in recent years, few energy companies have been investing more in finding new oil fields. Many companies also enacted significant capital-expenditure cuts in 2015-2016, which meant they had even less to spend on oil discovery. They have instead focused on cost control and cash generation. If this capital discipline remains in place, and if the price of oil stays stable, shares of energy companies could move higher – particularly given that a fluctuating oil price helped keep valuations quite low for years.

Some energy companies have prioritized "brownfield" developments that attempt to eke out more production from existing fields using cost-effective technologies. These efforts can help companies achieve quick cash-flow boosts, but the stock of these fields is increasingly limited. Indeed, a recent study from Rystad Energy suggests that, across the industry, reserve-replacement ratios have fallen to their lowest level in 70 years. While there may be no immediate impact, the effects of this fall in volumes could be felt on global supply over the long term. This figure is unlikely to pick up if there is no major investment increase.

In our view, this cutback in oil discoveries will start to filter through by 2019 and will noticeably reduce supply. For investors, it means the market could be looking at another oil-price spike not too far in the future.

4. The US shale industry has problems

In recent years, new technologies and drilling techniques contributed to a US shale-oil boom that significantly boosted supply and helped drive down oil prices. When OPEC nations restricted their oil production late last year, largely in an effort to combat low prices, US shale producers seized the opportunity to ramp up their output and exports. This further altered the balance of supply and demand in the global oil market.

Shale oil is a clearly profitable source of production for US energy companies, but it is important to note that the US is still a net importer of oil and other petroleum products. Moreover, the US shale-oil industry as a whole is grappling with some significant issues:

  • Many US oil producers are still cash-flow negative, relying on funding from banks and investors to provide enough cash to stay in business.
  • The robust pace at which drilling activity has increased over the past year is bound to decelerate due to growing constraints on available personnel and equipment.
  • As quickly as the shale boom started in 2012, the industry suffered a sudden recession in 2014. Consequently, much of the talent, skills and capacity used in the previous boom is now gone. So even though today's production levels are high, today's unsustainably low costs are beginning to increase rapidly.

President Trump is certainly looking to support US domestic production and is less environmentally focused than his predecessor, but it is unlikely his policies will have much impact on the location and pace of US drilling. For investment and employment to rise, the US shale industry needs higher and more stable prices. The general breakeven point is estimated to be in the USD 45-50 per barrel range – but only for the premier acreage. That leaves the large number of less productive fields more vulnerable.

5. Domestic production is falling in a booming Asia

Elsewhere in the world, China's domestic production is also in decline, and additional falls are expected. At the same time, China's energy demands are growing along with its population size. This suggests that China will increasingly continue to rely on the global markets to add to its supply. In addition, India, Indonesia and other Asian nations are also seeing production declines even as regional economic growth is expected to move significantly higher overall. This should lead to increasing demand from the global markets.

Today's low prices make oil an attractive opportunity for investors

On 15 May, Saudi Arabia and Russia announced an agreement to extend production cuts through March 2018 in an attempt to get surplus inventories under control. After this announcement, oil prices rose more than 3 per cent, to USD 52.52 per barrel. Only 10 days later, OPEC and non-OPEC nations agreed to extend their arrangement to cut production, and we shall see if the price of oil responds accordingly over time.

Eventually, of course, these OPEC restrictions will be unwound once inventories are reduced to normal levels, which should result in a more natural supply/demand balance. And as we have discussed, geopolitical tensions alongside a lack of exploration and new project sanctions appear set to reduce supply globally. This combination of factors should lead to historically low global spare capacity, which could lay the foundations for an oil-price spike.

We also expect to see excitement in the marketplace surrounding the impending initial public offering of Saudi Aramco, which is expected to be valued as one of the top 10 companies in the world. This could have a halo effect on the markets.

In recent months, the oil price has been depressed because the market did not see the quick inventory declines it was looking for; as a result, speculative long positions contracted. We believe this happened at least in part because of a lack of good data about global inventories, which meant the markets focused only on US numbers. Either way, inventories would normally be building during this period due to seasonality, and instead they are falling. We believe this contributes to an attractive longer-term opportunity for investors.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. This is a marketing communication. It is for informational purposes only. Any reference to a security does not indicate that such security was recommended for any client account. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Expert-Image

Neil Dwane

linkedIn
Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

As the West Ages, Asia Grows

Neil Dwane | 12/06/2017
Ancient Chinese architecture

Summary

Neil Dwane summarizes our recent AllianzGI Asia Conference in Berlin: Increased intra-regional trade, reform-minded leaders and positive demographic trends help Asia provide the growth and income potential that today’s investors need.

Key takeaways

  • With low growth and financial repression still plaguing many developed markets, investors need growth potential – and Asia is in a good position to provide it.
  • With the extraordinary future growth of Asia’s middle class, the centre of many investment opportunities for individuals and corporations is moving east.
  • Because growth in Asia can be fuelled and financed regionally, increasing Western populism and trade friction should have a smaller impact.
  • Key investment implications: China is still the main growth engine, but India is on the rise; Asian tech giants could outgrow US counterparts; Asian bonds may help investors earn attractive income; and structural reforms offer strong clues to growth potential.

Our clients and investment professionals recently met in Berlin for our annual AllianzGI Asia Conference. Here are some of the highlights from two days of discussions and events, which provided our guests with a host of investment insights about the world’s most dynamic region.

If the globalization tide turns, Asia can swim against it

Asia has long been a beneficiary and a driver of globalization – a force that has increased prosperity and opportunity around the world. In fact, after decades of globalization, the gross domestic product of Asia (excluding Japan) is twice the size of Europe’s when adjusted for purchasing power parity. And by 2020, Asia (ex-Japan) should provide 40 per cent of the world’s GDP.

Yet even if the political tide in the West turns against globalization and toward populism, Asia is well-positioned to swim against it. The growth of intra-regional trade within Asia should make America’s growing protectionism less menacing, at least economically. Moreover, China’s “One Belt, One Road” initiative should, over time, boost economic development throughout the region and across its frontiers. This should increase the size of many markets in Asia, which would give corporations an abundance of choice about where to invest their resources.

Reforms are changing how investors look at China

Over the years, investors interested in Asia’s growth potential have rightly focused on China, which has been transitioning from an economy focused on manufacturing and exports to an economy focused on services and consumption. China has a currently manageable overall debt burden, but its rate of growth will inevitably start to slow. Nevertheless, Beijing possesses the tools needed to manage growth – chief among them the ability to manage leverage inside its banks and state-owned enterprises.

For their part, China’s savers have developed a reputation for being very short term and aggressive in the demands they place on China’s banks. Yet there are new signs that – at least outside the property markets – the Chinese are looking to save for their health care and welfare in a more structured, sustainable fashion. Moreover, outside of China itself, Asia has a strong Chinese diaspora that is keen to invest in China’s prosperity, even if other international investors are awaiting the enactment of additional legal, regulatory and political reforms.

Reform will certainly be on the agenda at China’s Communist Party congress in November: Prime Minister Xi Jinping has kept up his reform efforts and projected stability as he prepares to present his Five Year Plan.

Elsewhere in the region, South Korea seems to be getting closer to making significant reforms to its chaebols – the Korean term for large conglomerates – to release innovative talent and excess capital for reinvestment.

Asia is experiencing significant demographic shifts

South Korea and China are, like the West, suffering from the greying of their populations. And despite increasing levels of household earnings around the region, there is still a risk that many Asians will neither save enough nor have enough children to survive without government assistance.

At the same time, there is an important mega-trend taking shape across the region: the emergence of the Asian middle class. While the global middle class has already grown at an extremely rapid pace, Asia is set to account for even more explosive growth in the coming years. This represents extraordinary potential spending power over the coming decades.

Asia’s overall population is also young, increasingly well-educated, technology-enabled and hard-working – and the median age is only 30 in Asia vs. 42 for Europe. The Philippines, India and Indonesia, in particular, are blessed with young and growing populations. Overall, this puts the region in a strong position, demographically speaking, compared with the US, Japan and Europe.

India’s prospects look increasingly bright

The ongoing attention many investors are paying to China may, in part, be obscuring the progress now underway in India and Indonesia. For its part, India has started to re-awaken as several of Prime Minister Narendra Modi’s policies become increasingly popular:

  • Demonetization is shining much-needed light into the “black economy”.
  • The new general sales tax should enhance government and state finances, boosting capital expenditures and reinvestment.
  • Aadhaar – a powerful biometrics-based identification system – should reduce corruption, ease unemployment and improve the distribution of subsidies.

All told, India could be inching closer to establishing a virtuous circle of progress, where better tax transparency leads to stronger government finances. This would lead to improved employment, and then to bigger markets. Next could come larger profit pools and better returns to equity investors, and so on. Either way, Indian companies have tended to focus more on profits and returns than their Chinese counterparts, which have generally focused on increasing market share. As such, investors in Indian equities should be rewarded by the improved growth and clearer political policies of the Prime Minister Modi era.

Disruptive forces are changing corporate behaviour in Asia

While the big US tech companies – such as the FANGs (Facebook, Amazon, Netflix and Google) – have held sway in other markets, they may not be able to fully capitalize on the true potential that Asia offers. That’s because their brands and culture may not be sufficiently local enough to appeal to Asia’s millennials.

Instead, a growing number of Asian high-tech firms – including China’s BATs (Baidu, Alibaba and Tencent) – are well-positioned to meet the needs of nearly 4 billion consumers in Asia. In fact, it is entirely possible that these names could become larger than their US counterparts, thanks to their ability to stay “plugged in” to what regional consumers want. It is also interesting to note that Europe has not produced any of today’s big-name, disruptive tech leaders.

Throughout Asia, as in most of the rest of the world, a greater emphasis is also being placed on environmental, social and governance (ESG) issues, which can have a positive impact on shareholder value and returns. This trend should create attractive long-term returns for global investors, who are seeing ESG-related issues gain traction among corporate management teams, core shareholders and outside interests.

Investment implications

  • Good valuations, still-positive real interest rates and low sovereign leverage help Asia offer sound growth potential and market returns.
  • China’s “One Belt, One Road” initiative should boost foreign direct investment, while trade agreements such as the Regional Comprehensive Economic Partnership could provide additional support for intra-regional trade.
  • Thanks to their knowledge of the region, Asia’s BATs could become even larger than the United States’ FANGs.
  • Tension with North Korea could boost regional volatility in the shorter term, particularly if China brings insufficient pressure to bear and the US fails to reduce regional hostilities.
  • In the global hunt for income, many shorter-duration, higher-yielding issues in Asia look compelling (denominated both in US dollars and local currencies).
  • Investors should monitor the pace of structural reforms, particularly in China and India: They provide investors with strong signals about the potential for future returns.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

184346

Expert-Image

Neil Dwane

linkedIn
Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.
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