Crude awakening

Disclaimer: The materials disclosed on this podcast are deemed to be sales desk literature and subject to our client communication policy and code of conduct as well as IIROC rules.

Shaun Sherman: If you had asked me that question about a month ago, I would have said there’s very little chance. But there’s been some recent leaks in the Iranian media that suggest that their economic struggles are risking some popular uprising. And there have been suggestions from some of the clerics to new president Raisi to go ahead and try to get a deal done.

Bipan Rai: Hello, everyone, and welcome to yet another edition of the FX Factor podcast and our first one for this year. So happy New Year to all of our listeners. There is a lot to talk about, and one of the things that I like to do with this podcast is to focus on specific topics and invite an expert from that area on to discuss it. For this episode, I wanted to talk a bit about what we’re seeing happen in the energy space, and I invited our resident expert, Shaun Sherman, who is in charge of Commodity Fundamental Analysis here at CIBC to talk about some of the developments that we’ve seen in crude oil and natural gas prices. Welcome back to the pod, Shaun, great to have you on.

Shaun Sherman: Yeah, thanks for having me.

Bipan Rai: All right. Yeah, it’s been a while since you’ve been on, and there’s certainly been a lot of developments in the crude and natural gas space. So why don’t we start off with crude oil. We’re a few weeks into the year already and we’re seeing crude prices up by 10 percent so far. That’s after a pretty hefty fifty five percent rise last year. In your opinion, what is the main reason behind this latest rally?

Shaun Sherman: Yeah. Well, the simplest explanation is that the demand recovery continues to outpace the supply recovery. That’s resulted in OECD storage relative to demand falling to the lowest level since 2018. And not coincidentally, that’s the last time prices were this high. In addition to the thin inventory level, we have supply outages in Ecuador, Libya and the US that have been about half a million barrels a day each. These disruptions have more than offset monthly quota increases from OPEC, which nominally are point four million barrels per day.

Bipan Rai: So walk me through the supply shortage story here a bit. How much capacity does OPEC+ have at this point to ramp up production if need be?

Shaun Sherman: Well, there’s a wide range of estimates on OPEC’s spare capacity, given the price crash in the lack of investment during the pandemic. But we think that it’s concentrated in four core members of OPEC, which are Saudi Arabia, UAE, Kuwait and Iraq. And we think that’s about three point four million barrels a day currently and see that declining to about one point six million barrels a day by year end. This is only about half of the pre-pandemic norm. So you can see we have a low spare capacity buffer and a low global storage buffer to offset any supply outages.

Bipan Rai: Right. So I mean, why are we here, though? Why isn’t there more ability to increase production globally? And I’m not just referring to OPEC+, I’m also referring to other producers as well.

Shaun Sherman: Yeah, well before this, the U.S. was a swing producer similar to OPEC. But as has been the case in most commodities, there’s been a lack of investment in supply due to poor returns before the pandemic, a shift to pay down debt during the pandemic to survive, and then uncertainty now about the long term demand picture for oil with energy transition. So investors are demanding a return of capital right now over growth in this environment, and even OPEC+ producers have invested less in the short term to shore up their finances, as I said before. But now balance sheets are improved, investors may accept some growth even though they want more return on capital than they got before. So I think that we’re starting to see the U.S. grow for sure. It’s just going to take a little while to get back to where we were pre-pandemic.

Bipan Rai: And when you say a little while, do you mean several quarters? Are we talking several years here?

Shaun Sherman: We expect year over year growth this year of a million barrels a day, but we would not get a new annual record until 2023 and then most likely, not a monthly record until 2024. So we’re a ways off still.

Bipan Rai: So what about OPEC+, what’s your read on them going forward? What can we expect from the cartel at the next meeting and also over the coming quarters?

Shaun Sherman: Yeah. Well, the latest production cut deal that they did in July last year called for them to raise quotas by point four million barrels a day each month through September 2022. That came with the option to pause three times by the end of this year. But given the current supply deficit, it seems most likely that they’ll just go ahead with those point four increases every month through September. Consuming countries, including the U.S., may press for more again, but they already kind of fired their bullet with the SPR release that is going on right now, and the OPEC doesn’t really have much incentive to go ahead with more and faster increases, given that their spare capacity is already low. But I think there are two things that can alter that. They don’t have an interest in seeing oil rise above one hundred dollars, given that would hit the economy and accelerate the energy transition so they could go and increase by perhaps point eight one month and try to get ahead of price increases. The other thing would be a U.S. Iran nuclear deal, which would bring back Iran’s a billion and a half barrels a day to the market, and that could actually cause them to pause or perhaps even cut.

Bipan Rai: Well, I’ll circle back to the Iran question in a few minutes, but I want to get your take on whether or not we’ll see something akin to what we saw at certain points last year where the OPEC+ deal seems to start fraying. Or at least there seems to be a few members that aren’t too happy with the production quotas. You see the risk of that happening and what’s the end game here? Does that September deadline get rolled even further out?

Shaun Sherman: Well, I think they all see the strong incentive to continue cooperating. And given that spare capacity, like I said, is really concentrated in very few members, you know, no one can really make a stink about supply quotas, and it doesn’t even matter if they did because they couldn’t even reach that quota. So it’s really about what does Saudi Arabia want, what does the UAE want, what does Russia want? And they’re all fine with their quotas at the moment. And the only thing that would make them want higher quotas is if the world really needs more oil and they’re the only ones that can supply it. So at this point, the trajectory seems to be one where just a few countries have all the control and everything’s going just fine for them.

Bipan Rai: And another question because I know this is going to come up from time to time. Is there a risk that the U.S. might release even more SPR or tap further into their SPR if need be?

Shaun Sherman: Yeah, legally there’s questions about how much Biden could act unilaterally to do that. Congress could certainly draught a bill to do it. The U.S. SPR is well in excess of requirements of 90 days of import cover that are set by the IEA. In fact, they could probably draw down about half of the SPR, which is currently 600 million barrels before they get to that level. There are already some mandated sales that go through even the early 2030s that kind of cut that down. But there is a risk that if everybody got behind it, including Congress, that the U.S. could release a good amount of oil.

Bipan Rai: All right, so let’s circle back to the Iran situation. I mean, it’s still looming large over the crude and in other markets as well. Do you see any resolution to that theme in the coming months?

Shaun Sherman: Shaun Sherman: If you had asked me that question about a month ago, I would have said there’s very little chance. But there’s been some recent leaks in the Iranian media that suggest that their economic struggles are risking some popular uprising. And there have been suggestions from some of the clerics to new president Raisi to go ahead and try to get a deal done. It’s still up in the air. I think it’s still about 50 50, but that’s a lot better than closer to zero, as I thought before. And the U.S. has basically imposed a deadline of late Jan. to early February. So I think we’re going to know pretty shortly which direction this is going. But even if a deal were to be met, it’s likely to take several months for this to play out. And Iranian oil will probably not come back until the second half of 22 at best. But once it does, and depending on the timing that could force OPEC to either pause or even cut their production quotas to make room for Iran.

Bipan Rai: Let’s switch over to natural gas now, and we know that prices have increased there as well recently. Can you hash out why for our listeners, why is prop natty so big?

Shaun Sherman: Yeah. Well, it’s off quite a bit from where it was in Europe in particular, which has been where most of the headlines have been. In the first half of 21, it averaged in a pretty normal five to 10 dollar per BTU range. And currently it’s around twenty five to 30, which is quite high compared to that, but that’s down from a peak of sixty dollars. This traces a lot back to the same story as oil, where demand has recovered faster than supply and there’s been a lack of investment in supply. But there are other factors as well, including carbon pricing and Europe effectively forcing the switching price for coal versus natural gas a lot higher. And that price has effectively been exported to Asia as well and its competition for LNG volume with Europe. And finally, Russia has drastically reduced its exports, in particular this winter, in an effort to encourage the quick approval of Nord Stream 2. That’s a pipeline that would allow it to export gas to Europe, Germany and bypass Ukraine.

Bipan Rai: So what’s the latest on Nord Stream 2? Certainly, we hear a lot about the static there and what’s happening, but what are the different parties stand on it so far?

Shaun Sherman: Yeah. Well, Germany definitely wants it approved. Russia obviously wants it approved, and most of the other countries are either indifferent or definitely do not want it approved, including Ukraine, obviously, and other eastern European countries. It’s currently stuck in German and EU regulatory approvals. The first step is Gazprom converting a subsidiary from the Swiss to a German company. Once that’s done, Germany and the EU each have about a couple of months to sign off on this, which puts a timeframe for in-service probably around October, just ahead of next winter. But that assumes that the pipeline does not get further tangled in tensions with Russia and Ukraine or sanctioned by the U.S. So there is still some chance that the pipeline never gets completed.

Bipan Rai: And you brought up a good point with respect to the Russia Ukraine situation, and of course, we did have talks there between the U.S. and Russia. What’s the end game there that you see? I mean, is this really just going to drag on into a stalemate and we really don’t get any sort of resolution? Naturally, that will have implications to Nord Stream 2 like you just mentioned, what do you think is going to happen over the next couple of months or so?

Shaun Sherman: Well, I can see Russia continuing to press the issue because they have the upper hand, for sure. The EU has an energy shortage right now and Russia is a huge supplier, so they don’t really have any leverage there. The U.S. recognizes that so they can apply sanctions. But I think that the impact of those sanctions can only be limited given the leverage that Russia has. I think that Russia is really looking for some concessions here that they’re likely to get.

Bipan Rai: And what about the situation in Kazakhstan? Do you see that continuing to be a risk or is that more or less being contained for now?

Shaun Sherman: Yeah, it’s been contained by Russia. Russia does not want that country to destabilize, and they immediately sent in troops, of course, at the request of the Kazakhstan government. But that situation seems to be largely resolved. And that’s been, I guess, maybe I don’t know if stable is the right word, but that country has been a stable commodity supplier for many, many years. So I expect that to continue to be the case.

Bipan Rai: All right. Excellent. So now’s my chance to once again hold your feet to the fire. What are you expecting for crude prices and natural gas prices over the next couple of quarters? And what are your upside and downside risks to this view?

Shaun Sherman: Yeah. Well, until supply for oil exceeds demand, prices should remain at this level. But the risk, obviously that it spikes to ninety dollars plus if there are further supply disruptions in the short term. But we do see supply exceeding demand somewhere in the Q2 timeframe, which should allow prices to pull back into the sixty five to 70 dollar range for 22 and 23, given the storage builds that we expect over the full years. The biggest downside risk to prices is a quick Iran deal, which brings back that million and a half barrels a day, as I said, and may even force OPEC to have to cut. For natural gas prices, definitely more focused on the U.S. In general, we think that prices have upside risk. We do see that the current forward curve should ensure sufficient supply assuming normal weather conditions. But normal weather is a tall task these days. So if we were to get any kind of cold, the elasticity of both demand and supply are much lower. And so if we get cold weather either this winter or next winter, once again, we’re in a regime where prices can go much higher to try to close the gap to Europe.

Bipan Rai: Right on. So if I were to say, what’s your target for the end of Q1 and also by the second half of this year, what will you give me for prop crude?

Shaun Sherman: For prop crude, I think by the end of Q1, we should be down in the seventy five dollar type range and by the end of the year, we should be closer to 70.

Bipan Rai: That fits in nicely with what we’re expecting for those petrol currencies this year as well. Given again that we are embarking on a rate hike cycle for several central banks, including here in Canada, we do think that the foreign exchange element or the Canadian dollar will take less of an impetus from what’s happening in the commodity space and start focusing more on front end spreads, which we expect to converge between Canada and the United States. And to us, that means that there are building risks towards a weaker Canadian dollar as we move into the second half of this year. And of course, if we do see as softer commodity prices, potentially a retracement back for prop crude to the 70 dollar range that Shaun mentioned, that should also further protests our view for upside the dollar CAD which we see potentially hitting the one point ninety to one thirty area instead of often here. So with that being said, Shaun, thanks again for joining us today. We’d love to have you back and best of luck, and let’s keep an eye on the crude market and see what happens next.

Shaun Sherman: Yeah, thanks for having me.

Bipan Rai: Cheers.

Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s) ,except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.