investment insights
Oil and gas prices diverge amid changing commodity dynamics
Key takeaways
- Brent crude prices are rising amid supply disruptions and signs of firmer demand. We expect them to keep trading at the top of a USD 80-90/barrel range
- Oil prices at current levels should not derail the general trend of falling global inflation, nor our projected path of US and eurozone monetary easing this year
- Natural gas prices have fallen to pre-Ukraine invasion levels, helping the eurozone economy
- The current macroeconomic and geopolitical environment is supportive for many commodities. Our structural and tactical US exposures benefit from its status as a major energy exporter. We also have a tactical preference for energy firms.
Rising oil prices are fanning investor concerns that sticky inflation could delay or derail rate cuts ahead. Yet sharp falls in natural gas prices mark the end of a multi-year energy shock and should herald the start of a European recovery.
Oil prices approached a six-month high in early April. Attacks on Russian oil refineries and rising tensions in the Middle East have raised concerns about supply disruptions. The Organization of the Petroleum Exporting Countries and key non-members (OPEC+) are maintaining their existing production cuts until end-June, which has been tightening the oil market balance.
There are also signs of a nascent recovery in global oil demand, especially with rebounding US and China manufacturing indices. Investors are now questioning whether oil prices will get squeezed higher, and are paying more in derivatives markets to guard against rising prices.
Yet some OPEC+ countries have been exporting more barrels in recent weeks, probably to partially offset curtailed Russian production. The organisation’s current spare capacity is capable of meeting current supply disruptions – if it is willing to step in.
If current conditions continue, we believe OPEC+ will gradually unwind some of their voluntary production cuts in the second half of 2024. Oil prices in the high 80s or low 90s are well above the level many OPEC+ countries need to balance their budgets. Pumping more barrels to offset supply disruptions elsewhere would ease their fiscal conditions. While current oil price levels have not proved harmful to global consumer demand, this may change if they shift higher, a risk OPEC+ wants to avoid.
Of course, risks to supply extend well beyond Russia. They include scenarios such as stricter sanctions on Iranian or Venezuelan output, or a conflict escalation affecting seaborne transportation in the Strait of Hormuz or the Red Sea which could put around one million barrels of oil per day at risk and see prices spike above USD 100/barrel. We discussed such scenarios here. But current spare capacity at OPEC+ exceeds this level.
Looking ahead, we expect Brent crude to continue trading at the upper end of a USD 80-90/barrel range. Rising demand should keep prices supported in the second half of 2024, as should OPEC+’s desire to proactively manage supply to stabilise prices.
Oil prices and inflation fears
Higher oil prices in recent weeks are fanning existing investor concerns over sticker-than-expected inflation, and the ability of US and European central banks to cut interest rates in the months ahead. Consensus rate cut expectations have already declined sharply this year, and futures markets are now divided on the prospect of a Federal Reserve (Fed) June rate cut, from seeing it as a near certainty just weeks ago. After geopolitical concerns saw oil head higher in early April, US 10-year yields spiked to five-month highs, putting stock indices under pressure.
Yet even at USD 90/barrel, Brent crude prices are below both spikes reached in 2023, and levels that prevailed for most of 2022. At current levels, we do not see oil prices derailing the global disinflationary trend, nor the path of developed market central bank policy. Counteracting more expensive oil, goods price inflation is falling fast, helped by cheap exports from China. While services inflation in Western markets is proving more persistent than envisaged, it is still on a downward trend. Rents are falling and, crucially, US and European labour markets are coming into better balance, and wage growth is coming under control. We still expect 100 basis points of monetary easing in the US and Europe this year, likely starting in June.
Natural gas prices falling
Meanwhile, changing dynamics elsewhere in energy markets are having a transformative effect. Natural gas prices have fallen sharply over the last 18 months. Europe suffered a severe energy price shock after Russia’s invasion of Ukraine, when it had to replace its main natural gas supplier. Gas prices in Europe spiked by 1000%+ as supply fell. But today prices are below pre-Russian invasion levels not just in Europe, but in Asia and the US too.
What is behind this fall? In Europe, energy markets proved more flexible to the removal of Russia as a supplier than many had anticipated. Countries sourced alternative providers, built new infrastructure to support liquefied natural gas (LNG) and ramped up renewable energy production. Natural gas demand fell by around a fifth on lower industrial use in response to high prices, while two successive warm winters reduced demand for heating – the main consumer of natural gas. Europe’s gas inventories are now approximately 60% full, a recent record for the end of winter, when depleted stocks usually start being rebuilt. Although the continent faces another uncertain winter before its infrastructure is fully resilient, it looks to have weathered the energy crisis.
Why are natural gas prices moving in the opposite direction to those of oil? Unlike oil, the gas market lacks a controlling cartel, and is temporarily oversupplied. US producers have ramped up LNG production, with more coming online in the next few years. A temporary freeze on new projects by President Biden will have little impact for now, given a 5–10-year timeframe before they come online.
Meanwhile, competition in the heating market from renewable energy has risen sharply, driven by a potent combination of government incentives, growing consumer demand and technological improvements lowering costs. Gas prices cannot fall much further without falling below the marginal cost of production for US LNG suppliers, who are now the world’s most important.
While the market may be oversupplied short term, there are powerful reasons to support long-term growth in demand. Natural gas is likely to continue playing a role in the energy transition even as renewable energy and nuclear production increase. The coal-to-gas shift in Asia, the biggest buyer of LNG, is still in its early stages. Demand for a constant supply of energy is also rising from data centres, due to trends in cloud computing, Big Data and artificial intelligence. This favours natural gas.
The energy shock recedes
The combined impact of lower oil and gas prices than in recent years is huge. Another of the post-pandemic shocks is normalising, and the volatility of inflation is falling with it. Europe felt the recent energy shock particularly acutely, and we expect eurozone growth to stage a limited recovery from a tough 2023 to around 1.1% this year. Lower inflation – driven in part by normalising energy prices – is helping real incomes in the bloc grow again. This is supporting consumption, the main growth driver. Both European manufacturing and consumer confidence are rising from low levels. Coal-to-gas switching in the power sector is lowering the carbon prices that companies must pay – a tailwind for European industrials.
How are changing energy dynamics reflected in our investment decisions? As the world’s largest exporter of both oil and LNG, the structural advantage of the US is reflected in both an increased US weighting in our strategic asset allocations and our current tactical preferences for US equities and the US dollar. We have also had a tactical preference for energy stocks since late 2023. These stocks have gained ground in recent weeks, and are benefitting from double-digit free cashflow yields, with favourable implications for shareholder dividends and stock buybacks. They also provide investors with a useful hedge against inflation.
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