Crude Reality

17 June 2025

Ironically, we had been doing work on oil and gas prior to the Isreal-Iran episode last Friday. Recent underperformance of the sector and a very high free cash flow yield (7.4%) suggested that oil and gas was interesting. On Friday Isreal carried out a wave of strikes against Iran, targeting nuclear facilities and killing senior military commanders. Israeli PM Netanyahu said the attacks targeted Iran’s nuclear and ballistic missile programs and the operation would last until the threat was removed.

The conflict escalated over the weekend. Prior to the episode, many analysts were bearish on oil given apparent spare capacity in OPEC+. The prevailing bias was spare capacity and the slowdown in global final demand would limit the upside risk to oil. However, Iran’s reprisals over the weekend and the potential closure of the Strait of Hormuz risk a much larger spike in Crude oil above $130 and a “Value-at-Risk” event for markets.  Historically, similar shocks have tended not to have an enduring impact. However, the Middle East tension hit with investors complacent and equity markets close to cyclical highs. Put another way, the risk-reward was poor with the S&P500 (global risk proxy) trading at 22 times forward earnings and in the 86th percentile of the 30-year valuation range.

It is important not to make structural observations to justify cyclical price movements. To be fair, regime shifts are difficult to identify and there can be overlap at major cyclical inflection points. Structural risk on the supply side has existed for some time prior to the Russia-Ukraine conflict and the episode this week. Resources have been depleting fast because the easier and cheaper to extract have already been extracted. At the same time, the global population is still growing, and energy consumption is still expanding. In that context, starving fossil fuel producers of capital might not have been a very wise decision. Of course, there has been a notable shift back toward fossil fuels or pivot away from “Net Zero” under the Trump Administration. Tactically, the recent conflicts in Ukraine and the Middle East, amplify structural risks.

Over the past 20 years, governments’ have spent around $5 trillion on green energy. However, the fossil fuel share of energy has only reduced from around 86% to 84%. Consensus estimates suggest that oil consumption will increase to around 107 million barrels per day by 2030. Currently, public listed companies contribute around 50% of global supply, but if future capital spending is constrained, non-public companies (primarily from OPEC) will likely be required to increase supply.

On the positive side, if prices spike or remain elevated for geopolitical reasons that might accelerate technological innovation and the transition away from fossil fuels. Capital spending from publicly listed companies has halved over the past decade, although it had started to increase since the low in 2021. As noted above, the free cash flow yield is very high for the MSCI World Energy sector in outright terms and relative to global equities (chart 1). Reduced capital spending, if sustained, will reduce future returns. However, with energy prices elevated, producers earn super normal profits.  

Chart 1

Source: Bloomberg

Tactically, prior to the episode last Friday, the cyclical outlook appeared challenging for crude. The contraction in the manufacturing ISM was consistent with lower oil prices (chart 2). As we noted above, the prevailing bias was that OPEC+ had significant spare capacity. Lower crude prices had also contributed to a reflexive or self-reinforcing fall in global rig counts. Of course, if there is a supply shock from the closure of the Strait of Hormuz that could be very disruptive for the real economy and markets.

Chart 2

Source: Bloomberg

Central banks tend to “look through” the impact of higher energy prices. Recall energy is a relative price – producers win at the expense of consumers. However, energy prices tend to be highly correlated with inflation expectations and bond yields. Inflation expectations are also elevated due to tariffs (where negotiations are ongoing and not complete). That will likely constrain the Federal Reserve from cutting the federal funds rate this week and over the coming months. In that context, the risk-reward for equities remains challenging. The energy sector is inexpensive at the current free cash flow yield and might provide diversification from other sectors. However, we note that the demand side for crude also remains soft and similar shocks have not had an enduring impact on markets. We do hold Woodside (AU) in our Asia portfolios.

20250617_Crude Reality.pdf

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