After slipping to as low as $73 a barrel earlier in June, the price of oil has enjoyed a steady climb upward. Hussein Allidina, Managing Director and Head of Commodities at TD Asset Management, explains why he sees more upside for oil prices from current levels.
Transcript
Greg Bonnell: After dipping to as low as $73 a barrel earlier this month, the price of oil has enjoyed a steady climb back to around the $80 mark. My next guest says we could see further gains in the commodity as we head into the summer driving season. And he has some interesting charts to help explain what’s happening. Hussein Allidina, Managing Director, Head of Commodities at TD Asset Management. Hussein, great to have you back on the show.
Hussein Allidina: Thanks for having me, Greg.
Greg Bonnell: So let’s go through these interesting charts you’ve bought. We were talking about the summer driving season. Summer is upon us, but also a few other things happening. Show us the picture and tell us the story.
Hussein Allidina: Sure, so I think the first chart shows US gasoline demand. A couple of weeks ago, US gasoline demand wasn’t as robust as it is today. As you head into the summer, it’s summer driving season. You’ve got schools in the US and Canada that are soon to be finishing. And you’re going to see, I think, a pickup in gasoline demand. What’s really, I think, supportive for the oil trade, for the refined product trade right now, is the fact that notwithstanding higher prices and concerns about the economy, which have been prevalent, I think, for some time, gasoline demand is holding pretty resilient.
We’re in the five-year average. And over the course of, again, the next couple of months, globally, we see a seasonal increase in demand in the tune of between 1.7 and 2.5-2.6 million barrels a day. So if you think about supply and demand, my demand, sequentially, is increasing pretty meaningfully over the course of the summer, which typically happens in the third quarter of the year. At the same time, that OPEC a few weeks ago came out and committed to keeping production constrained until at least September. So that points to what I believe will be pretty large draws over the course of the summer and part of the reason that we do think that there is upside in oil from current levels.
Greg Bonnell: So draws, summer driving season, but also tensions in the Middle East perhaps working on the other side of that equation.
Hussein Allidina: Yeah, so I would say six, eight, 12 weeks ago, a lot of risk premia in the market. You saw a lot of folks buying upside calls to protect their equity, fixed income portfolio, should there be an increase in hostilities in the Middle East and an increase in oil price. That seems to have largely been taken out of the market. You see the call skew getting softer and less interest in the market in upside. I don’t think that tensions in the Middle East are resolved. I think, if anything, we can see the Canadian Foreign Ministry came out this morning and advised Canadians in Lebanon to leave as quick as they possibly can. We do see that there is a buildup of troops on both sides of the border there, Israel, Lebanon. So I’m not sure that we’re out of the woods, by any stretch.
And in the context of reasonably tight fundamentals, tight inventories, improving demand, I think there’s a host of factors that point to more upside than downside here.
Greg Bonnell: All right, you guessed what I was going to say next here. Let’s talk about inventories. You can show us a picture of US crude inventories and the story that’s telling.
Hussein Allidina: Yeah, so US crude inventories – and I think part of the reason the market got a little bearish, or prices were weaker in the last several weeks, is because inventories were building. Now, they seasonally do build at this time of year. But if you look at it in a historical context, and that’s what I’ve tried to do here on this exhibit, inventories are extremely tight, and tighter, I think, than they’ve been – this data goes back, I think, to the mid-’90s. So, tighter than they’ve been since the mid-’90s. And demand has increased globally very meaningfully from the mid-’90s.
We get demand growth somewhere between one and two million barrels per annum every year. So think about how much larger your demand is today vis-a-vis where it was the last time inventories were this tight. I argue that we don’t have a comfortable level of inventory to contend with any potential disruption. And I still have demand increasing over the course of the summer sequentially. I think the landscape is quite a tight one.
If we look at the crude forward curve, crude has been, and remains, in backwardation, meaning that the refiner is willing to pay a premium to have that crude today, vis-a-vis waiting six months or 12 months, 10% more expensive to buy oil today versus taking oil for delivery a year forward. That indicates tight fundamentals in the market.
Greg Bonnell: So, if inventories are tight, demand is rising. Of course, you want to take more of the ground. One would assume you need rigs to do that. Rig count, what’s the story is that telling us?
Hussein Allidina: So, late last year, we saw US production rebound pretty meaningfully – surprised most people, ourselves included. A lot of that growth was private companies drilling to look more attractive as an M&A target. Today, when I look at the rig count, we’ve seen it actually fall. I think we’re sitting at levels that we haven’t seen since 2021. Yes, there are productivity gains occurring in the shale, which is allowing production to grow. But without incremental rig count, you’re not going to get the same type of production growth that we saw last year.
And, again, in the context of still growing global demand, we need to see increased production. This idea that we’re not going to be using oil five, seven, 10 years out, I think, to a certain extent, is limiting the willingness of folks to grow production, especially because projects take a very long time, outside the US shale, to bring to market. That sort of supply-demand balance looks concerning as I look into ’25, ’26, ’27, if I’m going to continue to use this stuff, which I believe we are.
Greg Bonnell: I’m assuming the industry is looking at the same data that you’re looking at. But you said, where is the incentive? Where is the incentive? And will it come?
Hussein Allidina: Well, so I think part of the challenge is that, today’s oil price, I should be seeing more activity than I am. But I think companies are loathe to invest for a host of reasons. One is the heat that they get from their equity investors, who have a ESG focus and don’t want to see this increased carbon footprint. On the other hand, this sort of, I think what is wrong, consensus idea that we’re not going to be using oil in five years – I think the IEA actually came out a couple of weeks ago and doubled down and said oil demand is going to peak again. They’ve been saying this for almost as long as I’ve been doing commodities.
If you look at the underlying data, demand is not decreasing. Demand decreases when GDP decreases. If you believe that the global economy is not going to grow, then there’s no pushback. I won’t push back on this idea that energy demand is not going to grow. But if your prior is that GDP is going to grow, energy demand will grow, the problem today, I think, is that companies are loathe to invest because ESG, and because of this idea that, hey, 10 years from now, we’re not using this commodity. I’m not going to spend $3-$4 billion bringing in upstream production that isn’t going to be producing for five years. I’m not going to break even on in 10 years. It’s a very dangerous, I think, dynamic that we’re seeing today.
Greg Bonnell: Well, let’s talk about it, then. I mean, if it’s a business and you’re looking at margins, you actually have a picture of refining margins for us as well. Is this part of the story?
Hussein Allidina: Yeah, so the reason I include refining margins is, refining margins have weakened from the highs that we saw last summer. So, you saw US margins, global margins, in the $30-40 per barrel range. And a lot of folks have argued that with margins down from those peaks that we saw last year, you might see a sort of reduction in crude demand. I’m still making $20-plus, if I’m a refinery, for every barrel that I refine. That talks to not only the tightness on the refining side. Just like we’re not spending money on upstream development, upstream production, we’re also not spending money to build refineries, because why would I build a refinery if I’m not using gasoline or diesel three, five, seven years down the road?
Today, refining margins are quite positive. That tells me that refiners are going to consume crude to make the product that you and I consume. So I include this chart because I think it points to the near-term upside that we’re likely to see over the course of the summer as seasonal demand increases.
Greg Bonnell: Well, let’s talk about positioning. What’s it look like out there? I think you’re saying there’s dry powder.
Hussein Allidina: Yeah, when I look at – so, this is data from the CFTC, the Commodity Futures and Trading Commission. And they show positioning in the market that is – this is net length. So this is the net length that the market – non-commercial or speculators hold in the market. What this is telling me is that there’s a lot of dry powder. If I look at where positioning is today, relative to history, we’re sitting on the lows. I think as the market tightens through the summer, you’re going to see more money that, again, is sitting on the sidelines – maybe it’s sitting in Nvidia, I’m not sure – come into the market and potentially send crude prices higher.
Greg Bonnell: We’re going to take a broader look now at the commodities market and the things you’re seeing out there, Hussein. Let’s start with gold. I think a lot of questions around this one.
Hussein Allidina: Yeah, so gold has traded, over the course of the last 12, 16, 24 months, probably more strongly than most people had anticipated. And I say that because, typically, we look at the dollar and real rates. And the dollar has been stronger. And real rates, broadly speaking, have been stronger. Typically, those are headwinds for gold. I think gold has performed because you’ve seen a lot of, specifically EM central banks, emerging market central banks, diversify their reserves.
If you look at their reserves in aggregate, these guys are holding 60%, 70%, 80%, 90% of their reserves in US dollars, or maybe US dollars and euros. I think, over the course of the last 12 months, we’ve seen a marked change in their appetite to hold gold. And that’s coming not just from China. People talk about China quite a bit. But you’re seeing it from a host of EM central banks. And a couple of weeks ago China came out and said, we’ve been buying a lot of gold, we’re going to pause. Gold traded down, I think, $60 an ounce that day, has started to grind back.
I think, again, and I’ve said this before on your show, the outlook for gold in the very near term, I’m not sure. I don’t know what the dollar does. I don’t know what real rates do on a one-week, two-week, two-month basis. But I think, medium term, if I look at how much paper, how much fiat is still held by the EM central banks, how little gold is held by institutional and retail investors in their portfolios.
And I think part of the institutional and retail lack of appetite for gold has been the resilience and robustness of equity markets, right? If I’m choosing between the S&P and gold, which is not paying anything, S&P goes up, it feels like, 5% every week. I’m kidding. But it feels like there’s a lot of inertia there. It’s clear that I want to hold equities. I think that when we see a bit of heartburn or anxiety in the equity market, that will support flows into gold from the retail side.
Institutionally, when you think about your portfolio construction, there’s very little in the tails of the distribution that you can own to protect your portfolio. Gold actually benefits you in those tails. And I think, in this world of inflation volatility – we saw the Canadian CPI print this morning – I think the interest in portfolio construction broadly is going to increase. And I think gold benefits from that.
Greg Bonnell: Interesting story on gold there. I know you want to talk industrial metals, particularly copper. What’s the story here?
Hussein Allidina: Yeah, so we were actually very constructive copper heading into 2023. We were constructive through most of the first quarter. We started lightning up on our copper exposure because we think it had moved too far, too fast – too fast, too far, whatever the saying is. The rally that we’re seeing in copper, that we have seen in copper that took us all the way to $11,000 a ton was driven primarily by this idea that as the Nvidias of the world need these data centers, you’re going to need more power generation. And to move that power, you need copper or aluminum, et cetera.
Again, we were of the view that it kind of had moved a little bit too fast. China is still in construction. Property in China is still very, very important for copper. I do think ultimately copper looks really, really good on a multi-year view. I think we’re going to have to see an improvement in the fundamental data in China. Now, we are seeing signs of social inventories drawing lower in China. TCRCs are quite tight. I think you’re seeing things improve. We like it more here at 9,200-9,300 than we did at 11,000.
Greg Bonnell: OK, copper story. I’m going to talk about a commodity now a bit different than the first two we’ve talked about – grains. What are you seeing in this space?
Hussein Allidina: So, grains, if you think about… we’ve talked about oil, we’ve talked about the metals. They take a very long time to see a supply response. If I see copper go, as we talked about, from 9,000 to 11,000, copper can go to 15,000. We’re not going to bring on new copper production next year. It takes seven to 10 years to bring on greenfield copper production. Oil, very similar, it takes three to five years to grow non-OPEC upstream production.
Grains respond materially quicker to changes in price. Again, it’s not Amazon Prime. It doesn’t happen overnight. But we saw high grain prices two years ago following Putin’s invasion of Ukraine. That, I think, has stimulated farmers to not only increase their area harvested on the margin, but they’re slightly more affluent, so they can put more love into the ground. They’re putting more fertilizer, better husbandry, et cetera. So you’re seeing better yields.
Now, take all that together. We are seeing corn, soybean, wheat inventories build. We’re not sitting at egregious levels of inventory, but probably not tight enough to justify the risk premia that you’ve seen in those markets over the course of the year. So we think they continue to decline as they have. I think the grain sub-component of the BCOM is probably down 15% year-to-date. It’s probably another 5-7% downside, in our view, in those grain prices.
The risk, of course, is weather. And the market has been fretting about weather. It was really, really dry and hot in the US a few weeks ago. Then it was quite wet over the weekend. If you look at those events independently, it can be quite concerning for yield. If you look at, in aggregate, hot, dry weather and replenished moisture levels is actually a great combo for yield. So we still think that yields are going to be quite nice this year. And that’s true for both South America and North America. There is, obviously, weather risks that we have to be aware of. But ultimately, I think the grains do trade lower.
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