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Why oil prices are plunging despite falling inventories

The oil price has recently lost momentum, with both Brent and WTI oil plummeting this week. A rather confusing trend is being observed in the oil markets: there is a large link between inventory data and oil prices.

Crude oil inventories have fallen below the five-year average for the first time this year. Last week, implied demand for gasoline increased by 992 thousand barrels per day (kb/d) w/w to a 15-month high of 9.51[ads1]1 mb/d, taking the monthly increase so far this year. Despite these positive inventory data, WTI prices has fallen from 83.26 dollars per barrel on 12 April to 68.85 dollars on 3 May while Brent prices has fallen from $87.33 to $72.54 per barrel over the time frame.

Normally, US inventories and oil prices have a strong inverse relationship, with falling inventories pushing prices higher while rising inventories have the opposite effect. However, large stock moves over the past couple of weeks have not been able to prevent significant price falls. As commodity analysts at Standard Chartered have noted, these shifts tend to be temporary and come at times when prices are mainly moved by other fundamentals in the oil market, expectations, broader asset markets and financial flows. In this case, recent optimism regarding OPEC+ production cuts has failed to counter demand concerns linked to a weakened economic backdrop and a hawkish Federal Reserve that is causing oil prices to remain contained. Furthermore, there are reports of it Russian crude oil shipments remain strong despite sanctions and embargoes: Reuters reported in April that oil cargoes from Russia’s western ports are on track to hit the highest level since 2019 at more than 2.4 million barrels per day.

Source: Standard Chartered Research

Fortunately, a cross-section of Wall Street still believes the energy sector is still good for the long term.

Goldman Sachs has advised investors to buy energy and mining stocks, saying the two sectors are positioned to benefit from economic growth in China. GS’s commodities strategist has forecast Brent and WTI crude to rise 23% and trade near $100 and $95 a barrel over the next 12 trading months, an outlook that supports their upside for gains in the energy sector.

Energy trades at a discounted value and remains our preferred cyclical overweight. We also recommend investors own mining stocks, which are affected by China’s growth through rising metal prices,“, the investment bank stated in a note to clients.

In fact, energy stocks remain really cheap, both by absolute and historical standards.

The energy sector is the cheapest of all 11 US market sectors, with one current PE ratio of 6.7. In comparison, the second cheapest sector is Basic Materials with a PE value of 10.6 while Financials is the third cheapest with a PE value of 14.1. For some perspective S&P 500 average PE ratio currently sitting at 22.2. So we can see that oil and gas stocks remain dirt cheap even after last year’s massive rally, thanks in large part to years of underperformance.

Rosenberg has analyzed PE ratios by energy stocks by looking at historical data since 1990 and found that the sector, on average, ranks in only its 27th percentile historically. In contrast to this S&P 500 sits in its 71st percentile despite last year’s big sales.

Even better, the outlook for the energy sector remains bright. According to a Moody’s Research Reportindustry revenues will generally stabilize in 2023, although they will fall slightly below the levels reached in 2022.

The analysts note that commodity prices have fallen from very high levels earlier in 2022, but have predicted that prices are likely to remain cyclically strong through 2023. This, combined with modest growth in volumes, will support strong cash flow generation for oil and gas producers. Moody’s estimates that US energy sector EBITDA for 2022 will clock in at $623 billion, but fall to $585 billion in 2023.

However, the analysts say that low capex, increasing uncertainty about future supply expansion and a high geopolitical risk premium will continue to support cyclically high oil prices.

In other words, there are simply no better places for people investing in the US stock market to park their money if they are looking for serious income growth.

Market deficit

But the biggest reason to be optimistic about the sector is that the current oil surplus is likely to turn into a deficit as the quarters go on.

Oil prices have only been treading water since the big initial gains from the shock announcement, with concerns about global demand and recession risks continuing to weigh on oil markets. Indeed, oil prices have barely rallied even after EIA data showed US crude stockpiles have fallen while Saudi Arabia will raise its official selling prices for all oil sales to Asian customers starting in May.

But StanChart has predicted that the OPEC+ cuts will eventually eliminate the surplus that had built up in global oil markets. According to the analysts, a large oil surplus began to build at the end of 2022 and spilled over into the first quarter of the current year. The analysts estimate that today’s oil stocks are 200 million barrels higher than at the start of 2022 and a good 268 million barrels higher than the minimum level in June 2022.

However, they are now optimistic that the construction in the last two quarters will be gone by November if the cuts are maintained throughout the year. In a slightly less bullish scenario, the same will be achieved by the end of the year if the current cuts are reversed around October.

By Alex Kimani for

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