Weekend attacks that sidelined more than half of Saudi Arabia’s oil production has sent crude prices sharply higher, but investors must still ask a key question: Can the rally continue if the global demand for oil remains lacklustre?
West Texas Intermediate crude, a North American benchmark, surged to US$62.90 a barrel on Monday, up US$8.05 or 14.7 per cent, its biggest one-day percentage gain in more than a decade. Canadian heavy crude, which constitutes much of Alberta’s production, rallied more than 18 per cent to US$50.49, up US$7.86.
Many Canadian energy stocks responded with impressive gains. Among Canada’s giant integrated producers, Suncor Energy Inc. rose 6.5 per cent and Canadian Natural Resources Ltd. gained 12.8 per cent. Among intermediate producers, Encana Corp. rose 16.3 per cent and Baytex Energy Corp. gained 16.6 per cent. And among drillers, Precision Drilling Corp. rose 8.7 per cent.
But the rally will likely meet skepticism from many investors, given the poor long-term performance of Canada’s energy sector.
As of Friday, before the attacks, the S&P/TSX energy index had fallen 25 per cent over the past decade. Occasional rallies during that period sputtered because of weak crude oil prices, export bottlenecks, rising U.S. energy production and lack of interest in Canadian oil assets by foreign investors.
Monday’s rise of 4.2 per cent for the index was its biggest in nearly three years and would have been even higher if not for its heavy weighting of pipeline stocks that are less sensitive to the price of oil.
But the factors required for a continuing energy rally are complex, as investors weigh the severity of the attacks on Saudi Arabia against a slowing global economy with a declining appetite for crude oil.
The U.S. Energy Information Administration, which has been frequently cutting its forecasts for oil demand all year, now expects oil consumption will increase just 0.9 million barrels a day in 2019 – potentially marking the slowest growth since 2011.
“We’ve all been conditioned to assume that major outages are bullish for the crude oil market, and they are. But in a weak demand environment, that complicates things,” Michael Tran, managing director within the energy research team at RBC Dominion Securities, said in an interview.
A paper published in June by the Oxford Institute for Energy Studies argued that disruptions in the supply of oil tend to be resolved relatively quickly with production increases.
“Historically, geopolitical episodes failed to produce large and persistent price increases, especially during periods of weak demand and abundant spare capacity,” Bassam Fattouh and Andreas Economou said in the paper. Mr. Fattouh could not be reached for comment Monday.
But a number of observers said that investors shouldn’t dismiss Monday’s rally, which followed the biggest-ever supply disruption, according to Bloomberg.
Mr. Tran noted the importance of rising sentiment among investors, as money flows back to a sector showing signs of life. As well, the energy market faces continuing geopolitical risks, especially if the United States or Saudi Arabia responds to the weekend attacks.
“When we think about the lesson from the weekend, it’s a lesson in vulnerability. Even if the current situation normalizes quickly, the threat of sidelining nearly 6 per cent of global oil production is no longer hypothetical,” Mr. Tran said.
Rory Johnston, a commodity economist at Bank of Nova Scotia, estimated that there was essentially no political risk premium reflected in the price of oil before the attacks. Now, he estimates the risk premium is about US$5 a barrel, assuming it takes several weeks for Saudi Arabia to resume full production.
“If it’s the worst-case scenario, and it takes months to get back to full operational capacity, we could easily have prices pushing US$70 per barrel or higher [for WTI],” Mr. Johnston said in an interview.
Some analysts pounced on the supply disruption with bullish enthusiasm for a sustainable rally.
Analysts at TD Securities argued that a US$5 increase in the price of crude oil will generate significantly larger cash flows at Canadian energy companies. The estimated cash flow gains (on a per-share basis) range from about 13 per cent in the case of Suncor to 18 per cent for Whitecap Resources Inc. and 55 per cent for Pengrowth Energy Corp.
Ray Kwan, an analyst at BMO Nesbitt Burns, raised his price target on Crescent Point Energy Corp. to $8 from $6 previously. Similarly, he expects the shares of Seven Generations Energy Ltd. will rise to $11 within a year, up from $8 previously.
“While it is unknown when Saudi Arabia’s production capability will be fully restored, we nevertheless think that a higher risk premium will be attributed to oil over the next 12 months,” Mr. Kwan said in a note.