Conflict in Europe: A Closer Look at Energy Market Fundamentals
Short-term oil price volatility will continue to make headlines, but we believe the clues to longer-term outcomes lie in the energy market’s supply tightness in place long before Russia’s invasion of Ukraine.
Highlights
- Jennison’s Global Natural Resources team expects short-term price formation in the energy sector to continue to be erratic. Current geopolitical uncertainty sheds light on more significant energy-market fundamentals: global supply was already extremely tight even before the Russian invasion.
- Supply constraints are driven by underinvestment and the ongoing production discipline of both OPEC+ and US shale producers juxtaposed with rebounding demand. Recent actions have effectively been an embargo on Russian oil supply and exacerbated supply pressures, a dynamic that we believe will be game-changing even if Iranian oil supply returns. Accordingly, pricing may have to reach demand-destroying levels.
- From a positioning standpoint, we have reduced our non-US energy exposure in favor of the United States’ lower cost of supply within a more stable political regime. We have also trimmed positions exposed to sanctions-related operational limitations.
Before Russia’s Invasion of Ukraine: The Journey of Oil Prices
Just two years ago, oil prices plummeted due in large part to the demand reduction spawned by COVID-19 lockdowns. Further, in the five-year period prior to the pandemic, oil prices struggled to maintain $60/bbl as production from US shale competed with OPEC volumes.
Pricing dynamics began to improve in early 2021 amid a rebound in global demand closer to pre-pandemic levels. The demand recovery from artificially low levels got a boost from widespread stimulus, while at the same time a more significant supply shift occurred as OPEC+ and US shale producers maintained oil production discipline despite increasing prices.
Notably, the Baker Hughes US oil rig count has only modestly increased and remains significantly below its pre-COVID peak in 2019 (Exhibit 1).
Upward Price Volatility in the Near Term
In addition to the explicit sanctions on Russian oil imports, market participants have instituted a de facto oil and gas embargo as would-be buyers have been wary of taking delivery of Russian oil for moral, legal, and logistical reasons. Challenges resulting from banking restrictions aside, even those who may wish to purchase Russian oil have found it hard to find a shipper able to transport the cargo. It may take weeks or months to resolve the shipping disruption, particularly as Russian supply re-reroutes to longer-haul buyers. Accordingly, the current price surge could find continued support.
Nearer term, if Russian barrels are only partially cut off from the market, we believe the potential for Iran sanctions relief and a modest level of price-driven demand destruction will regulate prices until trade flows normalize. If there’s a larger, more structural loss in Russian supply (i.e. some barrels are permanently lost due to embargos), any new Iranian production is likely to only slow the price ascent (not reverse it) toward a higher level of demand destruction. The United States and allies may also release oil from strategic storage but we expect any such relief will be temporary at best.
Longer term, we believe that the underlying fundamentals of the energy markets can sustain oil prices in the mid-$80s/bbl to the mid-$90s/bbl as demand is driven by a return to post-pandemic activity, global inventories remain low and the discipline of both OPEC+ and US shale producers remains strong. And while that price level is lower than that seen in the period directly following Russia’s invasion of Ukraine, it is significantly higher than what we believe has been priced into energy stocks, even after recent strong performance.
How We’re Positioned
We have no direct exposure to Russia or Ukraine in our global natural resources and infrastructure portfolios. Some of our energy and materials holdings have low-to-modest indirect exposure to these two countries through existing businesses and contracts.
From a positioning standpoint, we are reducing our non-US energy exposure in favor of what we believe are strong energy fundamentals in the United States. We have also reduced our positions in other global holdings that are impacted by sanctions-related limitations to business activity.
The US shale exploration and production sub-sector appears to be especially attractive at this point in time. Companies in this space are not directly affected by the conflict in Ukraine, yet they stand to benefit from the spike in energy prices. They have maintained capital discipline with their focus on creating value for shareholders through some combination of paying down debt, buying back stock and increasing dividend payouts (including special and variable dividends) to take advantage of this cash-flow windfall.
US natural gas companies should also benefit in this market. Around 70% of European natural gas arrives via pipelines, with Russia representing 35% of that supply (as of February 4, 2022)1. Limited spare pipeline capacity means the only incremental source is liquefied natural gas (LNG). US exports to Europe and the UK have increased by more than 90% in the last few months alone (as of February 22, 2022)2. This trend should accelerate once Europe builds more LNG infrastructure in an effort to diversify its supply at Russia’s expense.
Natural Resources in the S&P 500
A closer look at the S&P 500 index reveals that most investors are underexposed to natural resources. In the S&P 500, energy stocks represent less than 5% of the index as of December 31, 2021 (Exhibit 2). And the materials sector—which has its own tight commodity markets—also has a very small exposure in broad benchmarks. Given this dynamic, we believe global natural resource companies can introduce attractive diversification benefits in an investor’s broader portfolio allocation.
Jennison Associates
Jennison's investing approach is rooted in our fundamental research and security selection; all of our portfolios are built from the bottom-up, security by security.
Contact Us
Disclosures
1Source: Rystad Energy and the BP Statistical Review, as of February 4, 2022
2Source: US Energy Information Administration, Today in Energy, as of February 22, 2022
The views expressed herein are those of Jennison investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice and should not be considered investment advice.
The financial indexes referenced herein are provided for informational purposes only. All indexes referenced are registered trade names or trademark/ service marks of third parties. References to such trade names or trademark/service marks and data are proprietary and confidential and cannot be redistributed without Jennison’s prior consent. Investors cannot directly invest in an index.
Certain third party information in this document has been obtained from sources that Jennison believes to be reliable as of the date presented; however, Jennison cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. Jennison has no obligation to update any or all such third party information. There is no assurance that any forecasts, targets, or estimates will be attained.
The S&P index(es) (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Jennison Associates, LLC. Copyright © 2021 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC.
GICS Classification: The Global Industry Classification Standard (“GICS”) was developed by and is the exclusive property and a service mark of MSCI, Inc. (“MSCI”) and Standard & Poor’s Financial Services LLC (“S&P”) and is licensed for use by Jennison Associates LLC “as is”. As of October 1, 2009, Jennison Associates LLC (“Jennison”) does not reclassify securities classified by S&P/MSCI GICS. Only securities not classified by S&P/MSCI GICS will be classified by Jennison. Therefore, this report may include companies that have been classified by S&P/MSCI GICS or classified by Jennison. Companies classified by Jennison are not sponsored by the S&P/MSCI GICS classification system.
Important Information
This material is only intended for investors which meet qualifications as institutional investors as defined in the applicable jurisdiction where this material is received. This material is not for use by retail investors and may not be reproduced or distributed without Jennison Associates LLC’s permission. These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets.
Jennison makes no representations regarding the suitability of any securities, financial instruments or strategies described in these materials. In providing these materials, Jennison is not acting as your fiduciary. These materials do not purport to provide any legal, tax or accounting advice. Jennison Associates LLC (‘Jennison’) has not been licensed or registered to provide investment services in any jurisdiction outside the United States. The information contained in this document should not be construed as a solicitation or offering of investment services by Jennison or a solicitation to sell or a solicitation of an offer to buy any shares of any securities (nor shall any such securities be offered or sold to any person) in any jurisdiction where such solicitation or offering would be unlawful under the applicable laws of such jurisdiction. Please visit https://www.jennison.com/important-disclosures for important information, including information on non-US jurisdictions.