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'A new landscape' for energy markets: Recession fears outweigh oil supply concerns in 2023

Jovi Ho
Jovi Ho12/19/2022 08:00 AM GMT+08  • 6 min read
'A new landscape' for energy markets: Recession fears outweigh oil supply concerns in 2023
"The big transition in energy markets to lower-carbon fuels means that we're not likely to see as much exploration and development of new fossil fuel sources of energy." Photo: Unsplash/NASA
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The past few years have been volatile for commodities, as prices have been buffeted alternately by macro risks and geopolitical uncertainties, along with pandemic-induced shortages and inflationary pressures.

In the year ahead, fears of a looming global recession will be outweighed by persistent supply concerns. As such, Viktor Hjort, BNP Paribas’ global head of credit and equity & derivatives strategy, has identified energy equities as a top sector pick in Europe, as they are “supported by oil prices, and offer cheap valuations and double-digit free-cash-flow yields”.

With the energy transition and the coming winter added into the mix, “a new landscape” in the energy markets is emerging, says Andrew Harmstone, senior portfolio manager, global multi-asset, and head of global balanced risk control team at Morgan Stanley Investment Management.

“Another theme — which is related to the themes of rising inflation and challenging equity markets — is the new landscape in energy markets. The big transition in energy markets to lower-carbon fuels means that we're not likely to see as much exploration and development of new fossil fuel sources of energy. The war in Ukraine and subsequent pull back from Russian energy sources also means some of the sources of supply are not as reliable as one would like,” says Harmstone.

“All this reduces supply of these in the short term, so energy prices are likely to stay higher while this transition is going on,” he adds. “The investment implications are that we should maintain a cautious equity exposure but look for tactical opportunities.”

See also: What does a strong US dollar mean for investors of oil futures and options?

With the outbreak of the Russia-Ukraine war in February and output cuts by the Organization of the Petroleum Exporting Countries and allies (OPEC+), the energy sector was the best-performing global equity sector in the first 10 months of 2022, with returns of 33%, notes the UBS Chief Investment Office in its 2023 outlook.

In isolation, slower global growth is negative for the energy sector, but UBS thinks the oil market is sufficiently tight to support higher prices even if demand falls. “Sector valuations are a mere 7.4x 12-month forward earnings — a 50% discount to their 10-year average.”

See also: With food prices set to rise, how should investors trade agricultural commodities?

The Swiss bank believes energy stocks are underpricing the likelihood that oil prices will stay higher for longer. “We see near-term upside in oil prices, given gas-to-oil switching this winter, a likely end to OECD [Organisation for Economic Co-operation and Development] releases of strategic oil reserves and Europe’s upcoming ban on waterborne Russian crude imports.”

UBS forecasts WTI crude oil to reach US$107.0/bbl in March from a spot price of US$85.8/bbl on Nov 14. UBS also expects Brent crude oil to reach US$110.0/bbl from a spot price of US$93.1 over the same period.

Those elevated prices may arrive sooner than expected. In BNP Paribas’ 2023 global outlook, commodity strategist David B. Wilson retains his end-2022 Brent crude oil price forecast of US$100/bbl.

Yet, Wilson has cut his Brent forecasts for 2023 and 2024, as the market focus moves further away from under-supply to recession and demand destruction, despite a “significant” switch from gas to oil. “We expect the market to loosen in 2Q2023-3Q2023 based on weak demand, with Brent range-bound between US$92/bbl and US$100/bbl, supported by OPEC’s minimum US$90/bbl price target, but capped by demand weakness in response to higher prices. We expect the 2024 market balance to be in line with 2023.”

However, Wilson cites “significant” uncertainty around BNP Paribas’ base case, skewed to the upside, due to higher Russian supply risks following oil and oil product bans and a potential resurgence in Chinese demand.

Due to growth in US oil production, the WTI now trades at a discount to Brent oil. Says Wilson: “We expect the WTI discount to narrow but remain relatively high, for freight and quality reasons, at US$6–US$8/bbl for 2023 and then US$5–US$7/bbl in 2024.”

See also: Investing in oil amid OPEC+ output cut and ESG concerns

Diversifying with oil

Beyond equity exposure, UBS recommends direct investment into oil. “Outside of equities, we think that selling volatility in crude oil is an appealing strategy. Longer-dated oil contracts continue to underprice the potential for energy prices to stay higher for longer, in our view, and an actively managed exposure to commodities can provide diversification benefits to broad investment portfolios.”

James “JB” Mackenzie, managing director of Charles Schwab Futures & Forex LLC, stops short of recommending specific asset classes, but notes how interest in oil has swelled throughout the year.

“We neither recommend any products nor asset classes, but in 2022, we have seen continued volatility in the oil markets and self-directed retail investors have used retail futures to either hedge or adopt a risk-on position,” says Mackenzie to The Edge Singapore.

“As crude oil prices have fluctuated, retail client interest in those markets has been significant. As futures provide 24-hour access to the markets, five days a week, we’ve seen that they can be a significant tool in investors’ portfolios to help them meet their objectives,” he adds.

Micro-contracts for oil futures and options allow investors to buy exposure to crude oil for a fraction of the full price. Micro-contracts reflect actual oil prices; while avoiding fees, such as those levied on exchange-traded funds (ETFs), and bypassing potential corporate governance issues in public equities.

At one-tenth the size of benchmark WTI Crude Oil contracts, Micro WTI Crude Oil futures and options let investors trade on a smaller scale to manage crude oil price exposure with greater precision.

Over the past two years, broad commodity investments have delivered strong performance and provided significant diversification benefits for multi-asset portfolios, says UBS. “In the longer term, we think the sustained growth in demand for energy, food and transition metals, and the focus on energy sustainability and security, should continue to support prices.”

UBS highlights an “active approach” to investing in commodities, owing to the high level of cyclicality. “Portfolio exposure to rising commodity prices can also be achieved indirectly, through investments in equity sectors, or through countries and currencies with high commodity exposure.”

2022 has not been a kind year, and investors will need to remain vigilant in the year ahead, says Tan Min Lan, head, Chief Investment Office APAC, UBS Global Wealth Management. “But we think being nimble is also key to taking advantage of the turning points that arise.”

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