CCRV - How Geopolitical Risks Could Impact Crude Oil This Year

2024-01-20 04:37:00 ET

Summary

• The impact of slowing growth on oil prices.
• Are geopolitics being properly priced into oil prices?
• Why there might be opportunities in energy this year ?

Energy markets are facing numerous potential challenges this year, including unrest in the Middle East and uncertainty surrounding inventory levels. Hussein Allidina, Head of Commodities at TD Asset Management, discusses the implications for oil prices with MoneyTalk’s Greg Bonnell.

Greg Bonnell: The commodities market is carrying a lot of worries into the new year, oil and gas particularly challenged. But our guest today says a lot of pessimism already priced into the energy trade, and that could make the space interesting in the longer term. Joining us now with more, Hussein Allidina, Managing Director and Head of Commodities at TD Asset Management. Hussein, great to have you back on the show.

Hussein Allidina: Thanks for having me, Greg. Happy new year.

Greg Bonnell: Happy new year to you. We've got a few interesting things happening today. We have fears this year about slower economic growth, but we also have some bullish calls from several agencies about demand for the year. How are we trying to square this in our heads as investors?

Hussein Allidina: Sure. So, 2023, you know, demand growth was a concern through the bulk of the year. Hard landing, soft landing, no landing. The larger surprise, I think, in 2023 was better-than-expected supply. US production, shale production growth rebounded in the latter half of '23, and Iranian production actually increased by 500,000, 600,000 barrels a day, largely because sanctions were not enforced. There might be some politics there, you know, with inflation where it was. Maybe we let the Iranians export.2024, demand growth is going to slow, right. The COVID rebound, which saw demand growth exceed trend in the last couple of years, is going to get back to more normal levels. The IEA actually published their oil market report this morning, and they're expecting demand growth of 1.2, 1.3 million barrels a day. So, lower than what we've seen in the last couple of years --

Greg Bonnell: But still growth. Still growth.

Hussein Allidina: Still growth, absolutely. And this is very important, right, because we've talked before, the price of a commodity is determined by the intersection of supply and demand levels, right? The magnitude of demand is growing in 2024, as you mentioned. The uncertainty, I think, the market is grappling with is what happens to the supply side? The IEA is forecasting supply growth of 1.4 million barrels a day.

So, on paper, we should see inventories build by somewhere in the 200,000 to 300,000 barrel per day range in 2024. I think the piece that's important, and why I think we're probably trading, Greg, at the lower end of the range is because tremendous amount of uncertainty, right. Geopolitics, you mentioned, in the Middle East, obviously, top of mind.

But even if I build by 200,000 barrels a day over the course of the year, it's from very, very low levels, right? Inventories are sitting quite tight. Notwithstanding the fact that crude prices have come under pressure, the shape of the curve is still backwardated. That tells you that the market is still tight.

Greg Bonnell: With what's happening in the Red Sea, the geopolitical concerns in the Middle East, some people may take a look at the price of crude right now, just a bit under $74 a barrel for American benchmark crude, and think, where is the risk premium? How come this isn't in the price right now?

Hussein Allidina: Yeah, so, factually, a tremendous amount of potential supply that is at risk. To date, no supply has been disrupted. If you look at, you know, the last five, six, seven different sort of episodes of potential supply disruption, you've never made any alpha trading that, right?

I think the most recent thing that comes to mind is when the Houthis attacked the Saudis' facilities in the Eastern part of the country, you had a couple of days of materially higher oil prices. Production was brought back to market relatively quickly. I think, today, given we have three, four, maybe five million barrels a day of spare capacity, the market's a little bit sanguine about the potential for a disruption.

Now, the piece that concerns me there is that if we do see a disruption, the holders of spare capacity are primarily Saudi and the United Arab Emirates. They use the Straits of Hormuz, they use the Red Sea to a pretty elevated degree to move their crude. So I'm not sure it's fair to say, hey, we have a lot of spare capacity. If there is a disruption, we can meet that.

I think there's probably far less risk priced in than there should be. But, again, acknowledging the fact that, over the course of the last five, seven years -- the last time you got paid to trade potential supply disruptions was the fall of Muammar Gaddafi in Libya, a very long time ago.

Greg Bonnell: OK. So, important to keep an eye on there too. Of course, what's been overhanging this market for quite some time now has been central bank policy. We entered this year with expectations that the Fed was going to release the market thinking they would deliver a certain amount of cuts, and I feel like, in the past couple days, really, even with some of the data that's coming, people are wondering, what will the Fed actually do this year? How is that going to overhang the commodities market?

Hussein Allidina: Yeah, it's interesting, right? So, the last couple of years, a headwind for the commodity space has been higher rates, an attempt to slow the economy, and by extension, a materially firmer dollar, right? So, if we look, for example, at the price of crude, trading well off of nominal highs in US dollar terms, in India, as an example because of the weakness in the rupee, because of the strength in the dollar, Indians have been paying record-high crude prices for the better part of a year, a year and a half.

If the dollar weakens, because we see easing in monetary conditions, that should fundamentally improve demand in economies that are not pegged to the dollar, right. The macro, I think, has been a headwind for commodities over the course of the last couple of years. The micro has been quite supportive.

2024, there's some question marks around the micro, because of uncertainty around US production growth, uncertainty around demand. The macro is probably going to be more favorable from a sort of policy point of view as it relates to commodities.

Greg Bonnell: When we think about market watchers waiting for that first rate cut from the Fed, whether it's going to be March, whether it's going to be pushed out based on all this, commodity markets watching it just as carefully?

Hussein Allidina: I think so. I think the challenge today is that, you know, we're talking about cutting rates in an effort to kind of boost the economy, because inflation has come off. You know, you mentioned that we got some data out of the US this morning that is showing a firmer economy than expected, and expectations around rate hikes are potentially being reduced.

If the economy is actually running hotter, and that prevents the Fed from cutting, or central banks from cutting as quickly as the market is discounting, that should mean that the demand for commodities is higher today than the market is expecting. So it's a very sort of tricky, I think, period that we're in. Ultimately, though, again, I underscore the fact that inventories across the commodity space, with a couple of exceptions, are sitting at multiyear lows. Demand levels continue to increase, and the supply side, given the lack of investment over the course of the last 10 to 12 years, has left the supply side challenged.

If we get better-than-expected GDP growth, and, you know, I mentioned earlier that I feel like there's a lot of pessimism priced in, if we were to get slightly better-than-expected demand growth, whether it's for oil, for copper, et cetera, we don't have the cover to meet that demand.

So I think there's a lot of potential upside. I am, and I think the market is, concerned, though, that growth may not be I guess as robust as we're hoping.

Greg Bonnell: Is that potential upside a longer-term sort of thing? In the here and now, we've just done a nice rundown of everything that we're facing, but longer term, when you talk about underinvestment, I think you said a decade or more of underinvestment.

Hussein Allidina: Yeah, so, I think, the long term, I believe strongly that, over time, the global economy is going to grow. We can debate what growth might look like in the first half of '24, or in '24 as a whole, but there's a lot of inertia in GDP growth, and if the economy grows, that supply issue hasn't been addressed. And, you know, ultimately, demand will grow, and that will serve to tighten balances.

That's why I'm structurally constructive on commodities here and anticipate commodity prices will continue to perform over the course of the next five to 10 years. In the very near term, there is uncertainty around what growth will look like. And, again, when I look at positioning in the market, I think that the market has gotten too pessimistic, given fundamentals in the commodity market and given the potential for growth.

This time last year, we talked about Chinese demand growth. You talk to folks in commodities, very few of them are even talking or focused at all on what's happening in China. China disappointed relative to expectations this year. I think the possibility of them, you know, exceeding very depressed expectations is not being priced in.

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