- Oil prices are sensitive to supply and demand imbalances, which were originally disrupted by the COVID-induced demand collapse
- War and sanctions are now causing a non-fundamentally driven spike in oil prices
- Following our Hurdle Rate strategy, we made the recent decision to reduce our remaining oil exposure in traditional bottom-up investment strategies
Recent headlines summarize the oil industry’s response to the Russia-Ukraine War and subsequent sanctions that impacted energy supplies. Since Russia is the world’s third-largest oil producer (following the US and Saudi Arabia), and controls Europe’s supply, these sanctions were bound to have domino effects globally.
This is the latest in a multi-year story on how sensitive oil prices are to supply and demand imbalances.
The Original Opportunity
Oil’s supply and demand balance was originally disrupted by COVID and the pandemic’s abrupt decimation of travel. At one point in early 2020, the oversupply was so great that crude oil traded for negative prices, prompting an immense supply response by the industry, and creating opportunity for energy investors.
Then throughout the ongoing pandemic, when economies reopened, energy demand began to normalize at the same time as oil supplies fell. The market fell back into balance, and prices stabilized. Though subsequent variants periodically reignited demand fears, temporarily prompting aggressive sell offs, oil prices still marched higher as the economy recovered, eventually prompting those previously shut down supplies to come back online.
As a result, while we held significant positions across various energy companies, we started to trim our exposure. This decision resulted in an underweight position across most client accounts around the new year. At that time, oil prices were above the marginal cost of supply, which when paired with rising supply data, such as rig counts, further justified an underweight exposure.
It’s our responsibility to assess beyond near-term fears and focus on long-term fundamentals. In short, we believed that while supply discipline was strong, we knew that at some point, higher prices will cause oil capital expenditure investments to pick back up, boosting supply and potentially harming prices over the long run.
The Decision to Sell
Now, the ongoing war has caused a further increase in oil prices beyond what fundamental supply/demand analysis would indicate. That, plus the behavior of the overall industry, and our continuous monitoring of the commodity, have caused us to sell our remaining oil exposure.
The decision was driven by our disciplined Hurdle Rate strategy, which focuses on specific conditions that drive our buy and sell decisions in cyclical industries. Any decision to reduce exposure to any commodity is a function of industry conditions–a tightening of supply and demand driving up the price of the commodity, with returns for companies in the industry rising as a result.
Specifically, and as we look beyond near-term disruptions, high oil prices have led to a sharp recovery in industry profitability, and sharply higher debt and equity investment flows. Attractive returns on capital are, counterintuitively, a reduce/sell indicator under the Hurdle Rate strategy as higher returns are typically the leading indicator for increased investment in capacity, and it is the potential for excess capacity that precipitates the next down cycle. Though many factors impact the commodity, including the economy's increasingly cloudy outlook ahead, we will continue to monitor and analyze the industry to identify new opportunities and act as we see fit.
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This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. The reader should not assume that investments in the securities identified and discussed were or will be profitable.