Two years ago I laid out the reasons as to why I believed oil was about to enter a bull market and I presented investors some opportunities to capitalize on its rally…
Let’s review some recent history: Crude oil futures plunged into negative territory in April 2020, due to a surplus that left oil producers searching for places to store the oversupply. Like so many extremes in the market, this turned out to be a contrarian opportunity.
Today, the situation is much different. Oil is trading at about $111 per barrel and Energy is one of the few sectors that is in the green year-to-date (YTD).
As a result, this is no longer a contrarian trade. In fact, we are seeing index and fund managers forced to increase exposure to the sector.
The iShares MSCI USA Momentum Factor ETF (MTUM), a $10.8 billion fund, announced a major turnover in its holdings as it will reduce tech exposure and increase the weighting of energy, material, and value stocks.
This is the type of performance-chasing that is endemic on Wall Street and will happen in many other quant funds.
The contrarian inside of me bristles at this and immediately starts exploring the merits of fading these flows.
Despite my inclination, I was astonished to discover that the supply and demand dynamics of oil (and the larger energy sector) remain quite bullish even after the gains of the last 2 years. In fact, everyone should prepare for the unfortunate reality of much higher oil prices.
For most people, it will have a material impact on their finances and discretionary spending, but for some savvy investors, it could be a generational buying opportunity.
Here are 3 reasons that oil prices could go much, much higher from here:
Reason #1: Demand/Supply
Despite all the highfalutin talk about ESG, EVs, and futuristic technologies, the reality is that the world still runs on oil.
And, we precisely found out how important it was during the Covid-19 lockdowns, as demand declined much less than forecast by nearly everyone, including economists, oil companies, and investors.
To be precise, the world consumed an average of 91.4 million barrels of oil per day in 2020 vs 99.7 million barrels per day in 2019.
2021 bounced to 96.5 million barrels per day, and pre-pandemic demand levels should be exceeded this year. By 2026, it’s estimated to be 106 million barrels per day.
This demand growth is due to more people entering the global middle-class which brings buying of cars, washing machines, A/Cs, etc. In most years of positive nominal growth, this is enough to offset the dent in demand from increased efficiency and non-renewable energy use.
On the supply side, production hasn’t increased as fast as demand. A glance at earnings reports reveals that producers are focused on paying down debt and returning money to shareholders rather than taking advantage of higher prices by aggressively expanding.
Prior bull markets in energy haven’t ended until we saw years of higher-than average CAPEX spending. So far, we haven’t even got 1 quarter of above-average CAPEX.
Reason #2: Momentum, Momentum, Momentum…
Politicians like to blame financial markets for the woes of the people.
Most of the time, it’s bunk. But as a market practitioner for many years, there is no doubt in my mind that momentum traders often take trends to extreme ends.
Just think about all the madness surrounding meme stocks. The momentum trade feeds on itself and is often accelerated by the hype-filled chambers of social media.
I shudder to think of this happening to oil… but, it’s a distinct possibility as one of the few assets that is not only trading higher YTD but is up almost 50% since the beginning of 2022.
Reason #3: The Great Rotation
Over the last decade, growth and tech stocks have outperformed by a significant amount. However, as we’ve seen in the past few months, inflation and higher interest rates is leading to a reversal of this trend.
At its bottom in 2020, oil & gas accounted for just 2.3% of the S&P 500. Today, energy accounts for only 3.7% of the total index. To compare, oil & gas accounted for 30% of the index in 1980 and 15% in 2010.
My theory is that institutional money still is not coming into the sector. That’s because energy stocks have enjoyed huge gains over the last 2 years but they still haven’t seen significant multiple expansion.
Therefore, institutional money entering the energy sector is another potential catalyst.
Reason #4: Russia…
The big gamechanger for oil in 2022 has been Russia’s invasion of Ukraine which led to Western countries placing sanctions on Russian energy.
European countries are pivoting towards new sources of energy and could face a crisis in the short term in the event of a heatwave or a cold winter. Already, there has been rationing of industrial production to ensure that households have power.
Of course, North American energy producers are a big winner.
But, it’s important to note that a resolution of the war could lead to a short-term drop in the price of oil. However, it’s unlikely that the sanctions will be lifted anytime soon even if Russia is defeated and leaves Ukraine.
Therefore, this dip would likely be another buying opportunity.
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SPY shares were trading at $384.25 per share on Friday afternoon, down $5.21 (-1.34%). Year-to-date, SPY has declined -18.85%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.
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