Counsel Views – Gushing about oil and energy

Stu Morrow:

Welcome to Counsel Views. I’m your host, Stu Morrow, Chief Investment Strategist at RBC PH&N Investment Counsel.

Driven by unexpectedly high demand and catastrophic hurricanes halting production, oil prices have been climbing, hitting highs not seen since 2014. As analysts point out, cold winter weather and a busy pandemic travel season should only boost prices further.

The recent surge in oil, coal, and natural gas prices from China to Europe has also highlighted the fragility of the energy supply chain at a time when the world is trying to transition towards renewable resources. The worsening energy crunch may likely only be one of many similar shocks the world is to experience in the next few decades. This is because demand for fossil fuels will remain strong, but supply may be less certain.

With me today to discuss what’s been happening within the energy market and the outlook for oil is RBC Capital Markets Managing Director for Global Energy Strategy, Michael Tran. Michael is responsible for views pertaining to energy markets, including macro supply and demand fundamentals.

He also leads RBC’s Digital Intelligence Strategy research platform, a newly formed data science driven team. The mission of Digital Intelligence Strategy is to leverage alternative data sets to identify the hidden themes in society, to unearth actionable investment opportunities spurred by changes in societal behaviour and real-time global events. Michael has spent nearly 15 years in research, sales and trading, and investment banking with major banks like UBS, based in London, and energy trading platforms like BP, based in Calgary. Michael’s market views are frequently quoted in media outlets, and he routinely appears on television networks like Bloomberg, CNBC, and BNN. And he is a frequent advisor to both the Canadian federal and Alberta government on issues pertaining to energy policy and budgeting.

Michael, welcome to Counsel Views.

Michael Tran:

Stu, thanks for having me. Great to be with you.

Stu Morrow:

Great to have you. Lots to talk about. Maybe we could start with your overarching, bull-oil message this year, which involves, as I understand, a three-step process to structurally higher oil prices.

So could you walk our clients through your process? And where we are in that cycle?

Michael Tran:

It’s a great question, Stu. So, look. Over the course of the past half-decade-plus—seven, eight years—this market has been perpetually oversupplied. And we’ve just had too much oil out there; we’ve built too much inventory out there. And, as you know, I mean, oil prices have been subdued for much of that time.

Now, this time last year, I set out a three-step process for how do we get to structurally higher oil prices. This contained the first step of getting rid of the iceberg of storage, that backlog that we’ve built up during the early days of COVID. Number two, it’s the running down of OPEC spare capacity from historically high levels last year that we saw. Number three is, as we draw down on storage, as we run down OpEx spare, we’re effectively peeling back the shock absorbers in this market. And that leads us to the idea that, by this time next year, we’re going to need an increase in call on U.S. shale.

So that’s the SOS signal to the market, that after a decade of U.S. production growth spoiling oil market price rallies, we get to the point late next year where we’ve exhausted other options for the oil market, and we must call on U.S. shale to grow meaningfully to prevent the market from overheating. This is the most bullish catalyst that I can think of.

So, in essence, again we’re working through the first step of—first two steps at the moment. It’s a methodical process. It’s going well. Because we’re drawing inventory so aggressively, we think that we’re in a structural period of backwardation. But the major theme this year that we’ve really been highlighting to investors is the re-rating of the back end of the curve. When you ask generalist equity investors, what gets you excited about energy again, or at least makes energy difficult to ignore as a sector, it’s the re-rating of the back end of the curve.

Now, what I’ll also add here is that we still think that we’re in the early innings of a multiyear-strong oil cycle. Now, some investors will say to us, isn’t that what you said this time last year? And oil prices have doubled in the past year; surely, we must be further along in the cycle.

And so, what I’ve realized is that many investors mistakenly confuse or conflate a cycle by thinking about it in price terms rather than thinking about it in duration terms. Stu, when you ask the average investor what drives oil prices, they’ll often say, well, supply and demand. And I don’t actually think that’s correct. Look. If you study oil-market history, most oil cycles are not led by supply and demand. They’re led by supply or demand, at any point in time, but rarely both at the same time. Usually there’s a dominant force where one takes the back seat to the other.

I think next year is going to be one of those really unique years. And if we’re even directionally right about this, next year’s going to be the first year in a decade, or closer to 15 years, when we’ll see demand strength leading alongside supply-side tightness as the co-pilot. And I think this is what’s becoming increasingly visible to the market, when both of these things, supply and demand, lead at the same time.

Oftentimes in history, this is what we call a super-cycle. And this is what I think makes this cycle really unique, Stu.

Stu Morrow:

That’s very interesting, kind of going back in previous cycles and looking at what’s been the dominant force.

And if you kind of weigh those factors into your outlook for next year and beyond, what do you think is sort of the highest price? Or where is the top of this at the current part of the cycle in terms of price for oil? Where do you think it could go—$100 a barrel, $125 a barrel? Higher? What are your thoughts?

Michael Tran:

Yeah. Great question. So, look. To be frank, I don’t like to use the term super-cycle because it gets people too excited. And people automatically go towards the $150 barrel, 170—can we get there? I mean, look. We had a discussion that’s very similar to the podcast that we’re doing today. I had a discussion with an energy company, board of directors of an energy company recently. And as I talked through these themes, the first question was, well, can we see $200 in this cycle, right?

So I think when I use the word super-cycle, people get really excited. So we typically try to refrain from that and we try to talk about the strength of the cycle and how early we are in. Because if we can get investors into this market, into this sector now, we think that you’re going to have a pretty good multiyear run, irrespective of how high prices really go.

Now, what I think is really interesting is, to your point, the media is hungry for headlines of $100 barrel lately. Right? I mean, you’ve seen those headlines, triple digits, more and more frequently. Now, can we get there? Sure. Look, I mean, oil is synonymous with volatility, but I do think it’s much easier said than done over the very near term.

Now, our fundamentally based price modelling suggests that in order to get to $100 price environment, not just on a one-touch or a sprint, but on a sustainable valuation level, we think that OECD crude inventories would have to drop by a massive 550 million barrels between today and June to justify $100-a-barrel Brent price for the second half of next year on a sustained basis.

Now, again, I say it’s easier said than done because, well, put 550 million barrels into context for us. Well, that’s effectively implying a stock draw that’s nine times larger than what we’re currently projecting at the moment.

Stu Morrow:

That would be quite the demand scenario.

And, likewise, on the flip side, Michael, if you can think about a floor, perhaps, in your outlook for the price of crude. Would it be something well below where we are today? Or how do you sort of think about that floor level?

Michael Tran:

Yeah. It’s a great question. So if we tackled the last question by saying, look, we are currently trading around $80 right now, and $100 is $20 higher than that; why don’t we use the same framework or logic to make this a symmetrical discussion.

So with that, let’s say, how hard is it to get to $60 a barrel from $80 a barrel? It’s actually very hard as well. So, look. Our math would indicate that the market would have to see a stock build—so global oil inventory build—by 1.1 million barrels a day between today and mid next year, to sustain $60—to have prices plunge to $60 a barrel, on a sustained basis through the second half of 2022. A 1.1 million-barrel-a-day build, stock build, compares to our expectations of a 225,000 barrel-a-day draw.

So effectively, to see prices plunge and sustain at or below $60 a barrel, we would need to see a 1.3 million-barrel-a-day swing in inventories in the opposite direction from what we are currently guiding towards. So, simply put, we would have to be way wrong for a scenario like that to play out.

I know, Stu, you’re thinking, famous last words here. But look. I think the bottom line is just really trying to highlight how hard it is to get to a level like that.

Stu Morrow:

Sure. No. No. It’s all very logical. I think the famous last words are, well, at least it’s different this time.

Michael Tran:

Exactly.

Stu Morrow:

You didn’t say that so we’re all good.

The risks to your outlook, if you could talk about those. Is it China? Is it India? Talk about maybe sort of on the demand side where it would be. And then maybe on the supply side where the sort of biggest risk to your view on the outlook for oil is.

Michael Tran:

Yeah. It’s a great question. So, look. Coming into this year, if you ask the general investor, what are the biggest risks to the oil price, to a bullish oil price view this year, coming to 2021, people would say, well, north of $50 a barrel, U.S. producers would step on the gas pedal—step on the pedal again. I was going to say gas pedal, but no pun intended there.

Number two would be, OPEC would probably not be able to stick the landing. I mean, in a higher price environment, you would get OPEC start to break apart and certain countries would just want to increase production, again, in a higher price environment.

Number three would be the idea that with Biden taking the White House, you would see Biden trying to revive the Iranian nuclear talks. A deal would get done before the Iranian elections this past spring, and, as a function of that, you would have Iranian barrels coming back to the market.

The reason why I highlight those three ideas is because those are all ideas on the supply side that could have torpedoed the market this year, and none of them did.

As a function of that, I think, going to the last few months of this year and also into 2022, there’s more certainty around the supply side than we’ve seen in many years. And the reason why I say that is, look, this market has been one that’s been underinvested in for a decade and, as a function of that, as U.S. producers continue to stay disciplined, OPEC continues to stick the landing, there’s very few surprises on the supply side that could torpedo this oil market rally and bring prices lower.

Now, with that, your questions about, well, China and India, I think, are really, really relevant, those are demand-side questions. I think what’s really important in here is, we have seen demand return very close to pre-pandemic levels right now.

Going forward, China is certainly an area, a part of the world on the demand side, that concerns me. And here’s why. China and India have become central pillars of oil demand growth over the course of, not just the past decade, but many decades now. And what I think is really important is that, when you think about oil demand over the course of the past several years, you had demand growth of—the past decade—you had demand growth of 1.2 million, 1.6 million barrels a day, year in and year out.

What we saw was, the emerging markets made up virtually all of that, except for what came from the U.S. So if virtually all of that demand growth came from the emerging markets, when you actually look at, well, the centre of growth that came from emerging Asia made up two-thirds to 70% of that.

So, in other words, what I’m trying to highlight, Stu, is this idea that emerging Asia has been such a central pillar of demand growth, that if countries like China, if countries like India were to wobble, we would get really concerned about this market.

Now what’s really fascinating is China’s actually taken a back seat over the course of the past several months. Chinese imports are at multiyear lows. They’ve actually been quite low for the past six months.

Now, what’s interesting is, if you think about China—and China’s always a black box—but if you think about the policy measures now, I mean, the reason why they’re importing less is not because consumption is weak in China, but they think oil prices are too high. So what they’ve effectively suggested or signalled to the market is, we’re going to draw down on our strategic reserves. They’re doing that for the first time in history. We’ve never seen this before.

So in essence, Chinese policy is something that concerns us. I mean, when you look forward the next several months, could we likely continue to see weak imports? I think the answer is probably yes. And here’s why. Look. Beijing is hosting the Winter Olympics in mid-February. As part of the goal of putting on a performance or an exhibition for the world as you host Olympics, what China’s trying to do is, well, they’re trying to paint the sky Beijing blue right now. And as a function of that, what you’re doing is you’re telling your refiners to run at lower utilizations. You’re telling—you have other measures to try to reduce pollution as well.

So as a function of that, we can model the economic factors of China, but when there’s policy measures that change course, it makes China a little bit more difficult to think about over a short-term to medium-term process. So China, to us, continues to be the biggest risk factor in the market.

You also touched on India. Look. India had—they grappled with COVID over the course of the spring and parts of the summer, but what we’ve seen with the latest data is India’s fully back in growth mode. So we anticipate that with infrastructure buildout, et cetera, we’re just going to continue to see further growth from India and most emerging Asian markets over the coming months and quarters, Stu.

Stu Morrow:

Thanks, Michael. I love the logic and the flow of your thesis around the demand coming from China, especially. I think that’s pretty key for people to follow and you made it quite clear. So I think that’s great.

And it’s amazing we’ve got back to the world we’ve sort of came to know before COVID. Demand has certainly come back in many respects, and economic growth has picked up. But we’ve seen COVID cases pop up, like in Europe.

How do you think about the demand picture as COVID continues to play out? Vaccination rates are up and that’s all great, and. But how do you think about that as perhaps maybe a risk or an evolution in the demand picture?

Michael Tran:

Right. So, look. This is such an important question. I mean, as part of a broader digital push for our firm, RBC, we spent months sourcing, building, and curating two indices that we launched over the course of the summer. We came up with what we call our GOAT index, which stands for get out and travel. We also came up with what we call our GOAL index, which stands for get out and live.

So, if you think about what these indices capture, it effectually reflects real-time changes in mobility patterns. Effectively, we can tell you how mobility is changing on a day-by-day basis, on a week-by-week basis, for many different parts of the world. So clear implications for oil demand.

Now, Stu, we also built a predictive model to forecast what mobility across North America and Europe would look like based on fresh COVID case counts. And to your comment, we are seeing new Delta variant highs in places like Europe right now, and Germany is leading that.

But I think the takeaway from our modelling is that, for places like Europe, for places like the U.S., we found that COVID cases are no longer impacting societal behaviour at a level that can be statistically explained. So what does this mean?

This doesn’t mean that our models are broken or wrong. This simply suggests that societal behaviour is less elastic and, therefore, less explainable by new COVID cases today than at any point in the past 18 months. So, in essence, new COVID cases are now becoming statistical noise.

Now what I think is important is, you may say, well, don’t we kind of already know this from an anecdotal perspective? I think the answer is yes. But I think what’s really important here is that the ability to quantify this with big data, real-time data, is really reassuring for a lot of investors who will invest in energy, will invest in the reopening trade.

Look. With vaccines, COVID fatigue, the antiviral pills that have recently been announced, again, government regulations that are seemingly being peeled back, at least here in North America. Again, anecdotally, we already knew that we all had a degree of COVID fatigue. All you have to do is look at how busy restaurants are, shopping malls, or college football games are now. But, again, I think the statistical approach is just really much more powerful than just anecdotes.

So I think that the idea here is, as we all started to take back portions of our lifestyle, what we’re seeing is, even as COVID flares up, we’re less likely to give back, to go into self-quarantine or isolation as a function of that. Look. I mean, this is a bit of a rhetorical question but, Stu, when’s the last time you stopped—or when’s the last time you wiped down your groceries coming back from the grocery store? I mean, I’m hoping it was at least 16 months ago.

Stu Morrow:

That’s right.

Michael Tran:

But I think the idea here is how liberating was that feeling when we first stopped realizing that we didn’t have to wipe down our groceries anymore?

So, look. I think that being able to quantify societal behaviour in real time and the application to oil demand is just really so important, given intermittent COVID flare-ups or the potential for an alphabet soup of future variants; even if we move—hopefully move closer to an endemic issue with COVID rather than a pandemic.

But in essence, we’re not overly concerned for oil demand, and that’s what our math would suggest at the moment, Structure.

Stu Morrow:

That’s excellent. You’re clearly doing a lot of great work at RBC. So, really, thank you, Michael. It’s been an absolute pleasure having this discussion with you. I know our clients at PH&N Investment Counsel really appreciate it. And I do hope, at some point in the future, we can have you back on, and maybe sometime in 2022, we could talk about where we are in the energy markets at that time.

Michael Tran:

Perfect. Let’s do it in person. Looking forward to it.

Stu Morrow:

Definitely. Thanks again, Michael. Take care.

Michael Tran:

Thanks for having me.