An Oil Stock to Ride Out the Looming Recession

At the moment, the oil market is much like the famous quote from the beginning of “A Tale of Two Cities.”

It is a tale of two markets: the futures market for oil (controlled by Wall Street) and the physical market, which reflects the real-world demand for oil. Both factor in many dynamics inputs, notably whether we’re actually heading into a recession.

Which Tale to Believe?

The price of oil dropped by about $15 a barrel in a few days in the futures market, thanks to recession worries. That pushed the global benchmark Brent crude oil price below $100 per barrel for the first time since April.

However, in the real world, there is no sign of a slowdown in demand for oil. In fact, it’s quite the opposite.

Premiums for the immediate delivery of oil are at record levels. For example, Nigerian Qua Iboe crude oil was offered at $11.50 a barrel above Brent, while North Sea Forties crude was bid at Brent-plus-$5.35—both all-time highs!

Here in the U.S., WTI-Midland and WTI at East Houston traded in June at a more than a $3 premium to U.S. crude futures, the highest in more than two years. And though both grades of oil have since edged off those highs, they are still trading more than 60% higher than at the start of June.

Even in the futures market, while the Brent oil price has fallen almost 20% since May, the premium at which the nearby contract is trading to the second month — a condition known as backwardation, which implies tight supply—has widened to more than $4.00 per barrel.

So, we have genuine strength in the physical market versus the sentiment in the futures market. We have reduced Libyan and Nigerian oil production and Western sanctions on Russian oil flows, versus shorting by hedge funds.

What “tale” should we believe about oil? I lean towards believing the physically tight markets, which will keep oil prices biased to the upside.

And OPEC itself backs up this belief, too.

OPEC Forecast

The oil cartel expects global oil demand next year to rise to levels OPEC would struggle to meet.

The amount of oil the producer group is required to pump to meet global demand — the “call on OPEC crude” — could rise to as much as 32 million barrels per day by the end of next year.

That is close to or greater than most estimates of its maximum production capacity, raising concerns of a global supply deficit in 2023 if oil demand grows as OPEC expects.

In its first forecast for 2023, OPEC said it expected average demand to rise by 2.7 million barrels per day next year to 103 million barrels per day, driven by increased demand in India and China.

To bridge the gap between supply and demand, OPEC would have to pump an average of 30.1 million barrels per day. Seasonal variations in demand mean the call on OPEC oil could reach as much as 32 million barrels per day in the last three months of the year — approximately 3.3 million barrels more than what OPEC members produced in June.

Investment Implications

While OPEC may be somewhat optimistic on demand, I do not see a world in which we are awash in oil, sending the price plunging.

The recent selloff in oil stocks should not have come as a surprise. The S&P 500 energy sub-index, comprised of 21 oil and gas companies, jumped by 29% in the first half of the year, adding more than $300 billion in market capitalization. Meanwhile, the wider market recorded its worst half in more than 50 years, shedding more than $8 trillion, or 21%.

The longer-term pressures that have been pushing oil stocks higher had not changed. Any weakness in the stocks is a potential buying opportunity.

For example, Shell PLC (SHEL) recently said it expected to revise upwards the value of its oil and gas assets after the company raised its long-term outlook for oil prices amid increased demand and disruption to energy flows driven by Russia’s war in Ukraine.

Shell increased its 2023 price for Brent crude to $80 per barrel and said it would reverse up to $4.5 billion in writedowns previously taken on the value of its upstream oil and gas business. The total value of Shell’s production and exploration assets was recorded as $125.5 billion at the end of 2021.

Restrictions on exports of Russian refined oil products has exacerbated a shortage of global refinery capacity, pushing up prices for refined products such as diesel. Shell’s refining margins in the second quarter almost tripled to $28.04 a barrel from $10.23 in the first three months of the year! This increase will boost earnings by between $800 million and $1.2 billion.

And let’s not forget that Shell is the world’s largest trader of LNG. Global demand for LNG has soared as European buyers have sought alternatives to pipeline gas from Russia.

This translates to an extremely safe quarterly dividend, which Shell raised in the previous quarter from $0.48 to $0.50 per share. The current yield is 4.1%.

There is likely more to come for shareholders. Shell is considering boosting shareholder returns on the back of bumper profits from soaring energy prices.

CEO Ben van Beurden told Reuters, “We have to look after our shareholders because I think our shares are very significantly underpriced, and therefore giving back more to shareholders to help that part of the equation is going to be very important.”

Shell is a buy anywhere in the $50 range.

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About the Author

Tony Daltorio is a seasoned veteran of nearly all aspects of investing. From running his own advisory services to developing education materials to working with investors directly to help them achieve their long-term financial goals. Tony styles his investment strategy after on of the all-time best investors, Sir John Templeton, in that he always looks for growth, but at a reasonable price. Tony is a regular contributor for InvestorsAlley.com.

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