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WTI Weakness on China Lockdowns; E&P Corporate Fundamentals Remain Solid

Updated: Jun 12, 2022

With crude oil futures advancing by +11.5% since Russia’s February 24 invasion of Ukraine (or +36.5% YTD), we thought to take an updated look at the current supply/demand fundamentals, as provided by data compiled from the International Energy Agency (IEA). Citing the continued global slowdown, the most recent projections released earlier this month amount to demand being 99.4M bbl/day, continuing a trend of negative revisions which follow the previously expected 99.7M bbl/d forecast from March, and down from the 100.6M bbl/d forecast from February. That said, FY/2022 global demand is expected to increase by approximately +1.9M bbl/d, a decrease from the approximately +3.0M bbl/d as expected earlier in the year. On the supply side of the equation, the IEA expects Russian oil supply to fall by approximately -1.5M bbl/d in April and then drop another -1.2M bbl/day by YE/2022. Interestingly, the IEA believes that crude oil shipments to China and the EU (by pipeline) will not be materially impacted, however seaborne barrels will see a large decline. Regardless, the forecast is for global refinery throughput to increase by +4.4M bbl/day from now until August. Given the current shortages, refiners will likely have problems sourcing the incremental barrels as the global oil markets remain undersupplied.

In light of the recent pullback in WTI Crude (a -17% decline from the recent peak of $123/bbl on March 8, 2022) we believe that the risk is on the upside as we enter the Q1/2022 earnings period. Not only has crude pricing fallen recently due to hawkish Fed commentary (some advocating a 75bps rate hike) but the recent weakness is also due to the draconian lockdown measures initiated in parts of China. These measures implemented (and still on-going) shut down manufacturing and mandated that people remain at home, in line with the CCP’s Zero Covid mandate. With many Chinese ports, steel mills and manufacturing all in lockdown, one can see how the strict measures have prompted a slowdown in the Chinese economy and added to congestion in the global supply chains. Together, these combined factors have led to the recent weakness in crude pricing.

Though the lockdown is stated for an indefinite period, images of civil unrest and frustration in Shanghai (where some 26M people have been confined at home, relying on government delivered food rations) have started to circulate. Though the CCP remains committed to the Zero Covid policy, we think that the risk is on the upside for crude prices. Our bullish stance is predicated on the persistent Supply/Demand crude imbalance and with an easing of Chinese Covid restrictions expected to gradually begin.

Ahead of the Q1/2022 earnings releases, despite the recent weakness in the underlying crude price, the largecap upstream E/P sector continues to benefit from tailwinds such as a near decade high in pricing (lets put things in context) and strong underlying corporate health and cashflow - prompting many to increase dividends or announce large share buyback programs.

As can be seen above, largecaps such as Marathon Oil (MRO), Canadian Natural Resources (CNQ) and Cenovus Energy (CVE) have outperformed WTI Crude oil futures YTD. The notable underperformers have been Diamondback Energy (FANG) and EOG Resources (EOG). Collectively however, the sector has advanced by an average of nearly 40% YTD. For context, the S&P is down -7.8% YTD while the Nasdaq Composite is down -15.0% YTD. Though there are clear signs of inflation becoming more entrenched, GDP estimates getting revised lower and consumer sentiment becoming increasingly negative given higher commodity prices, we believe that any potential escalation in sanctions coupled with further supply destruction can further lift the price of crude to higher highs.

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