Andrew Sheets: Welcome to Thoughts on the Market, I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.
Martijn Rats: And I'm Martijn Rats, Morgan Stanley's Global Oil Strategist and Head of the European Energy Research Team.
Andrew Sheets: And today on the podcast, we'll be talking about supply and demand dynamics for oil markets in 2021 and the impact of environmental, social and governance considerations on global energy companies. It's Thursday, February 4th, at 3:00 p.m. in London.
Andrew Sheets: So, Martijn, one of the reasons I wanted to talk to you today is that you're at the center of these two really big stories that are going on at the moment. One is about commodities themselves, which are often very popular asset classes following a recession as the economy recovers and the other is ESG, where environmental considerations are increasingly important to investors and have depressed the demand for many energy related names.
Andrew Sheets: So, Martijn, let's take those in turn. When the global economy collapsed, we saw a large reduction of oil consumption. How are those oil demand figures looking now? And what does that demand side of the oil market looked like to you?
Martijn Rats: Yeah, thanks, Andrew. Long story short, we think that we're running somewhere between five, maybe six million barrels a day in terms of total oil demand below pre coronavirus levels. And to put that in context, normally oil demand is running in the order of 100 million barrels a day or so. Now, five, six million barrels a day of shortfall is actually, in a historical context, enormous. But there is a really interesting OECD versus no OECD story to be told. Non OECD oil demand is already back to pre coronavirus levels and pretty much as high as it's ever been. It's really in the OECD where the demand shortfall is the greatest, but that is really where you would expect vaccination to ultimately solve this problem, bring back mobility and therefore bring back oil demand.
Andrew Sheets: So the good news on the oil demand story could be that oil demand is pretty robust in some of these more traditional kind of emerging market economies, the non OECD economies. And it's weaker in the developed markets in the OECD. But that is where we think vaccine progress could be most optimistic?
Martijn Rats: I think that's correct. Look, on a sort of, you know, 10 year view, there is a whole different story to be told about the outlook for oil demand. But from a more cyclical perspective, it seems to me that the experience of the non OECD is indicating very clearly that coronavirus will probably not have a structural impact on oil demand, on the timeframe of the next several years. Vaccinations kick in in the OECD. It's very likely to us that also their oil demand comes back.
Andrew Sheets: And Martijn, so on the supply side, you know, one thing that was also making people very worried about oil was that, look as soon as the oil price would rise, you had a number of producers with very low cost, countries like Russia or Saudi Arabia or the US shale production community, that would just step in and pump more oil if the price went up. So why don't you think that will be a powerful enough force to just kind of depress oil prices further and prevent future rises?
Martijn Rats: Yeah, look, there are clearly two sets of countries in the context of discussion. There's OPEC or I should really say OPEC+, because these days, Russia coordinated oil policy very closely together with OPEC countries. So for all intents and purposes, Russia acts as an OPEC country. And then there are non OPEC countries and they're the countries that can add the greatest amount of supply. The quickest is the United States with its tremendous shale reserves.
Martijn Rats: We often tend to talk about U.S. shale as being short cycle as in it can respond quicker. And that's true, but it can respond quicker than traditional oil projects. But over the next 12, 18 months, U.S. shale will almost inevitably show declines over the next six to nine months at least. So there's an element of time in there.
On the other side of the equation, the countries in OPEC+ well, they are coordinating their policy very closely and they're showing a relatively strong degree of cohesion over the last couple of quarters, and there's a clear intention amongst that group to keep the oil market balanced, to work off inventories, which means keep the market in somewhat under supply - presumably, in pursuit of higher prices. So both in shale, things don't happen overnight either. And then OPEC, together with Russia, showing quite a bit of constraint. And, yeah, those factors continue to support the oil market.
Andrew Sheets: So, Martijn, that brings me to the second thing I wanted to ask you about, which was the environmental angle to the sector. There's obviously another side to that story, which is that that type of rise in oil consumption is potentially a major environmental problem against the backdrop of ongoing global warming.
Andrew Sheets: And so I wanted to ask you about how you think about those risks. But specifically, because this is obviously a headwind for investment in the sector, and yet this is also a sector that itself is going through something of an environmental transformation. And so let's kind of dig into that, and how do you see the pros and cons of that story playing out?
Martijn Rats: Yeah. This is a huge issue for investors. And there are really two ways to look at it. You can look at the absolute impact on the environment. And it's true that if you produce oil and gas, you know, that's associated with emissions. And clearly that is problematic. The other perspective that I also find a lot of investors are taking is not to look at this issue in an absolute sense, but in terms of a rate of change. Are companies improving and are they improving fast enough.
Martijn Rats: And in the context of that sort of second perspective, the year 2020 actually turned out to have some favorable side effects. 2020 was a tremendously difficult year for the oil industry, of course, but 2020 also drove home the vulnerability of the environment in a broader sense. A number of energy transition themes really accelerated during the course of last year. There is no debate anymore over the direction in which this should go. And that is towards new energies, decarbonization and renewables.
Martijn Rats: In fact, all oil majors that we cover here in Europe no longer have any growth aspirations in terms of oil and gas production, in fact, most of them are targeting or preparing for oil production to start falling pretty fast in the second half of the decade. So in that sense, 2020 has resolved a tremendous amount of sort of strategic uncertainty. And if that captures the imagination of investors, which I think it will, I think that that could relatively quickly put the sector in a different light.
Andrew Sheets: Well, I do think it's just a fascinating instance of how, you know, markets respond to incentives because, you know, the real story of 2020 was enormous gains for stocks that seem to have a good environmental story. That was one of the best performing sectors of 2020 and almost kind of independent of what was going on with coronavirus. And so you too, right? I think in your sector have this kind of irony where the most optimistic investment case is often around trying to revalue the business or appreciate the value that some of these businesses can have, in that kind of green transition. Do you think that's a kind of a fair way to frame it and think about it?
Martijn Rats: Yes, I think that's a very fair way of framing it. Look oil majors don't exist in isolation. They exist in a context, the context of the wider society, the people that they employ, the governments that they have to interact with, the customers that they're selling their product to. Sure they'll continue to develop new fields and produce oil for some time to come. But searching for new oil, for example, is already something that is getting almost the minimus investment because the resource base is large enough to carry them over for the next 5 to 10 years. These are some pretty drastic changes that investors should not underestimate.
Andrew Sheets: So Martijn, one other question I'll throw out there. It's 30 years from now. What does an oil major look like?
Martijn Rats: Yeah, that's an excellent question. Look, the entire energy system will need to move what we often call from molecules to electrons. The energy system currently largely based on fuel oil, gas, coal, is very sort of molecule centric. We burn something. The future energy system is one that is electrified where our energy demand is consumed in the form of electricity. The majors will simply move with that development.
Martijn Rats: So you'll see the oil majors entering offshore wind. You'll see them entering into solar projects, for example. But there are still a number of very hard to decarbonize parts of the economy and processes that are, you know, very heat intensive or where simply the energy density of fossil fuels is hard to replace. There hydrogen can play a tremendous role. Now, the hydrogen market is still very small. It will probably take a good 5 to 10 years to develop that. But hydrogen would suit the oil majors tremendously well given their current skill set.
Martijn Rats: So you'll see them move into these genuine green renewables, but also into things like hydrogen. Biofuels, also a way to address parts of the markets that are hard to decarbonize. So they'll be a mix of different energy outputs that they'll move into over the next couple of decades.
Martijn Rats: And, Martijn, just finally, what's your thinking on the sector? What's your current recommendation to investors?
Martijn Rats: For the first time in about three years, we have an attractive rating again. We think that the pace of change in oil majors is very positive in terms of responding to the energy transition, and they have much to work with. But at the same time, that happens in an environment where oil price is looking up. So an improving commodity markets rapidly greening businesses with valuations that at least in historical context we're looking at and we're finding quite compelling. So, yeah, for the first time in about three years, we recently upgraded the sector view again.
Andrew Sheets: Martijn, thanks for taking the time to talk.
Martijn Rats: Great speaking with you, Andrew.
Andrew Sheets: And thanks for listening. If you enjoy Thoughts of the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.