The price of oil has pulled back from recent highs amid fears a global recession could crimp demand. Greg Bonnell speaks with Andriy Yastreb, Energy Analyst at TD Asset Management, about what’s causing the decline and what it could mean for gas prices at the pump.
The price of oil has come off its highs as these recession fears increasingly on the minds of investors. But that hasn’t really translated to big price declines at the gas pump. Here to discuss that differential is Andriy Yastreb, Energy Analyst with TD Asset Management. Andriy, great to have you on the program. Let’s talk about that. You’ll see a day like this, we’ve had a few of them where there’s a big pullback in crude prices. I can forgive the average person for saying, “When’s the savings going to come through at the pump?” What’s happening there?
Well, it’s interesting. The energy prices are always volatile. And if you think about the market right now, it’s basically a tug of war between the fundamentals in energy industry overall, which is pretty tight. We have inventories that are very low. We have spare capacity at OPEC that is also very low. So we don’t have that much supply. We are also in the midst of a driving season, so a lot of people are finally taking their vacation, going out of town. So we see a lot of demand seasonally and all of that is driving demand for crude and for oil and gasoline up. At the same time, as you mentioned, there’s always this concern about recession, right? Like what’s going to happen next? And I think that’s what’s happening in the markets because on the one hand, you have very tight industry fundamentals. But at the same time, the financial markets have to think forward and think what will happen in 6, 12 months. And that’s why we see this volatility.
All right. You brought us some charts that help us illustrate what we see in the movement of gasoline, diesel prices and the American benchmark crude. Let’s start showing them the props. Walk us through this one right here. What is this telling us?
So, when people talk about energy and oil, they talk about different things. So this chart is showing three lines. The bottom line, the gray one, is price of oil. And when people talk about $100 oil, they talk about it in terms of dollars per barrel. And that’s what the chart shows. But as you know, when we talk about gasoline, we talk about gallons in the US or liters here in Canada, and we talk about $5 or $2. So this chart is basically putting diesel gasoline and oil prices at the same metric in terms of dollars per barrel. And what’s interesting here, if you look at just the grey bar, which is the oil, $100 oil, it’s expensive. It’s definitely increased a lot from where it was in COVID times, and shortly it was in negative territory. But if you look historically, we’re not that far from where oil was in 2011, 2014, for almost four years. But what’s interesting here and what’s different is that those green and yellow lines, they are pretty close to all-time highs here. And that’s interesting because what it tells you is that it’s not the oil price itself that is so high, it’s the refined product, the diesel and gasoline, that is really in short demand. And we can go through a number of reasons that’s driving that.
So that chart was showing nominal prices, I think. You have another one with the same three variables, but in real terms. What’s the difference there?
So, when we talk about $100 oil being expensive, I think there’s a difference here because $100 in 2012 is different from $100 today. Even if you think about 2% inflation per year, over ten years, that’s 20%. Right. So $400 oil in 2012 equivalent today should be $120 or even above that. So if we adjust for inflation, oil prices are actually below $100. And they look not that high compared to the period that I was mentioning, 2011, 2014. But if you look at the green line, that money is really way above that period and that’s close to the peaks that we saw in summer of 2008. And what’s driving that is that there’s a lot of demand for diesel globally, and there was a lot of demand for diesel as the economy recovered from COVID. But there are also supply issues on that side. So in North America in particular, there were several refineries that were shut down after COVID around the last couple of years. In Europe, there’s the situation with the Russian supply, because Europe was getting some of the diesel from Russia and because of sanctions they lost some of that supply. And on top of all of that, there is one country globally that has excess capacity on refining side and could ease this shortage. It’s China, but Chinese diesel and gas exports are down 40% year-on-year. They have quotas from government on how much they can export. And the reason for that is that Chinese government is committed to ESG targets. They want to reduce carbon emissions. And to get to those targets, they need to reduce how much they process oil and how much they export it. So far, at least, they’re committed to those targets.
So we take all these factors together, what you’ve been illustrating with us in terms of the relationship of diesel and gasoline to the American benchmark crude. And we know as investors that the energy sector has outperformed the TSX Index overall. We can show the audience just how much. And I guess the big question becomes, moving forward, what are we expecting out of the market?
Obviously, energy had a really good run here. And if you look at the prices basically since COVID recovery started, the energy sector doubled and was driving a lot of performance in TSX, and obviously recently, the last month or so, some of that outperformance has reversed as people started to get more concerned about recession.
How about the S&P 500? I mean, obviously, we know that energy is performing well as we’re taking a look at the picture of the relationship here on Bay Street. What about on Wall Street? I think we can show the audience a picture of that as well and walk them through it.
So here we go into a bit more detail in terms of what energy is. Obviously, we see the same kind of strong performance and recovery after COVID. What’s interesting here is that if you break down the sector into subsectors, the most volatile part is E&Ps, which is exploration and production companies. So that’s your shale companies, that’s your Permian companies. And those outperform when oil goes up and that’s what they’ve done, but also they underperform on the way down. If you look at the middle, the yellow line is integrated companies. That’s your large cap companies like Exxon and Chevron. They also have a lot of oil, but because they are more diversified, they’re not as volatile. And the last line, the blue line here, is transportation and storage. And those companies are basically or pipelines, companies that have long term contracts, they have more stable pricing and they underperform on the way up and they outperform on the way down because they have more stability.
In this kind of environment right now, we were showing the earlier charts and the relationship of the end product for a user and the crude oil, the integrated names, do they start to make more sense to investors if they want to be in the energy space?
In the short term, yes. I think if you look at this quarter, maybe next quarter, when we are going through driving season and demand is so high and those crack spreads, the difference between oil and product prices are so high. I think all the companies that have exposure to refining will have strong results. The more tricky question is how much of that is already expected by markets, because anybody in the market can see where the crack spreads are and how those differentials behave. And secondly, depending on what happens with the economy in recession, we’ll see what happens to those spreads going forward. So I do expect these companies to post really strong results in the short term. The big question for investors is what’s going to happen 6, 12 months down the road?
You talked about summer driving season a couple of times. Obviously, we’re all very anxious to get out, explore the world, experience the world, after everything we’ve been through in the past couple of years. Is there a price of gasoline at the pumps that’s going to stop us from taking that trip or is the market sort of saying people are so anxious to get in the world, they’re going to sort of just eat those high prices for a while?
Well, that’s an interesting question. And when you look at different sources and talk to different people within the industry, we get different answers. So it’s really hard to see if we actually see demand destruction right now. I would say that on the margin, probably, yes. But the thing is, it’s really hard to tell because we have seasonality, which is during the summer people want to go on vacation, to drive more, and that happens every year. And on top of that, we had COVID. So after COVID, a lot of people didn’t take that vacation because of lockdowns and health concerns. Now it’s time when everybody wants to get out, and we see that pent up demand materializing. So I think, my view is that if it didn’t have these high prices, probably demand would be even stronger. That’s my take. But it will be really interesting to see what happens in the fall when seasonality comes down and people are not taking vacations anymore. And we’ll see if there is actual demand destruction.