Partner at major asset manager explains why oil is rising, why he expects that to continue, and why pension funds may underperform without it
While there have been some recent swings back and forth, oil prices have risen steadily on aggregate this year. From lows of around $73.29 a barrel in December of 2023, Brent crude has been hitting prices at or above $85 per barrel so far in 2024. Much of that price rise has been attributed to geopolitical tension, but Eric Nuttall sees a longer-term story at work here.
The partner and senior portfolio manager at Ninepoint partners explained why he thinks attributing oil’s rise in price to conflict in the Middle East would be a ‘significant mistake.’ Instead he highlighted a range of longer-term factors influencing supply and demand that he believes should prompt Canadian institutional asset managers and pension funds to reconsider their approach to traditional energy investments.
“Any pension fund that has divested out of traditional energy over the past couple of years has underperformed,” Nutall says. “Even looking at this year, 40% of the TSX’s gains are from energy. Energy is the best performing sub index by far. I think going forward in a likely higher than average inflationary environment, commodities typically perform well in energy typically performs the best out of any commodity.”
Nuttall’s outlook is driven by a view of oil supply and demand that points to price drivers beyond just the conflict in the Middle East. Energy was oversold last year, he says, as investors overemphasized the continued production capacity of US shale. This year, US shale production has slowed significantly. OPEC+ has played a key role tool, having already announced a cut to global oil supply. Demand for gasoline, diesel, jet fuel, and other oil derivatives have increased to near record levels already this year.
What Nuttall predicts, therefore, is that global oil inventories will remain flat at a time of the year when they normally grow. Nuttall claims that all of these supply and demand forces should have played out over the coming months, all the geopolitical tensions did was accelerate their inevitable impact on the price of oil.
Nuttall is confident that the OPEC+ decision to raise prices, the downgrading of US shale production, and geopolitical risk premiums in oil should remain in place going forward. Often times OPEC+ is challenged when one or a group of its members decide to produce more than the agreed limits. Cohesion among the OPEC+ nations is strong, in Nutall’s view, in large part thanks to the leadership of Saudi Arabia’s energy minister.
US shale production often has a capacity to surprise analysts. Nuttall admits that US shale outproduced his own expectations last year, but the reasons behind that outproduction point to a slowdown now. Last year many private shale companies were sold to publicly listed names. Ahead of those sales, private shale companies ramped up their drilling and production to maximize cash flows and their valuations. Now under publicly listed ownership, the focus will be on profitability and shareholder return, which means that investment in production should tail off somewhat. He sees the overall rig count and productivity numbers falling already.
The geopolitical risk premium, Nuttall says, amounts to about $5 of the ~$85 oil price. Signs lately still point to greater escalation, amid news of potential strikes against Iran and the idea of escalation in a regional war. Nuttall expects that risk premium to remain in place for some time.
Where Nuttall sees some risk to his outlook is on the demand side. If central banks don’t cut interest rates before too much damage is done, there could be a wider impact on the global economy. If the US and Canada fall into a steep recession, there should be some negative impacts on the price of oil. However, Nuttall notes that OPEC+ has a playbook for those scenarios, and their willingness to cut and keep prices higher when demand drops has served energy investors well in the past.
Another trend that Nuttall thinks is positive for demand is the shift in the car market away from electric vehicles. EV sales have slumped in many developed markets and while consumers are conscious of both their carbon footprint and the cost of gasoline, they are mostly favouring hybrid vehicles. Hybrid sales are now well outpacing EVs and even standard internal combustion vehicles pointing to a consumer that is still okay with a hydrocarbon powered vehicle.
The other risk that Nuttall sees for oil doesn’t come from its physical market, where supply and demand are tight, but from financial markets. The financial market for oil, he says, is 30 to 50 times bigger than the physical market. If the financial markets use oil price contracts as a financial instrument there can be circumstances where the oil price falls despite high demand and low supply.
In this environment, Nuttall and Ninepoint think that the Canadian oilpatch offers opportunity for asset managers. While not as undervalued as they were six months ago, Canadian energy names still boast strong free cash flow yields and shareholder-friendly policies such as buybacks or dividends.
“Here’s an opportunity where you have a sector that remains profoundly out of favour due to ignorance around the long-term use of oil and natural gas in the global economy. All the data and evidence you can see on a daily basis points to a runway for oil and gas that will be much longer than the average person estimates, and yet you can buy companies using an oil price that is 10 per cent lower than where we trade today,” Nuttall says. “You can buy into companies with their strongest balance sheets in history. Many companies have no debt or very low debt, they’ve pledged to reward their shareholders for having patience and rewarding them with meaningful share buybacks and dividends.”
