Picture your Future. Save for it by earning 1.5% on a 1-year Term Deposit Account! Learn more.

Franklin Templeton Insights: Energy Markets in View

Commodity Markets in Disarray

Commodities have been soaring since the second half of 2020, and they continued to do so in response to Russia’s invasion of Ukraine since the former is a major exporter of crude oil, natural gas, nickel, aluminium, palladium and other commodities, while the latter is a major exporter of wheat and corn foremost. Events in Europe were seen as boosting global inflationary pressures and complicating supply chain disruptions.

The escalation of the Russia-Ukraine conflict led to the imposition of retaliatory sanctions by Western nations against Russia, translating into major supply disruptions—and the creation of stopgap measures among commodity buyers. Commodity markets were thrown into disarray by the move as Ukrainian grain-handling ports shut down and select metals refineries were idled. In Russia, liquefied natural gas (LNG) orders were paused, finance for the country’s raw materials trade evaporated and Black Sea wheat sales froze.

European natural gas prices spiked nearly 40% on the news as the wartime restrictions sparked concerns about potential energy shortages. As it pertains to oil, Russia produces over 10 million barrels per day (mb/d) of crude, about the same as Saudi Arabia. At an oil price of US$100 per barrel, Russia’s oil revenues are around US$365 billion at an annual rate currently. The European Union (EU) is Russia’s largest trading partner, accounting for 37% of its global trade in 2020. On average, the EU receives nearly 40% of its natural gas and more than a quarter of its oil from Russia.

Oil

US crude oil prices rose nearly 9% in February, while the international benchmark (Brent crude futures) surged above US$100 per barrel as supply—already stretched by rebounding demand and limited supply increases—was seen as tightening further as Russian flows were slated to be disrupted and buyers preemptively looked to secure less-contentious supplies elsewhere. The associated geopolitical risk premium pushed up current and forecasted 2022 crude oil prices throughout the month, culminating with a spike to the highest levels since 2008 as war broke out in Ukraine and as sanctions were drawn up against Russia.

There are three ways that global supply could be curtailed by the current war: Russia has trouble bringing oil to market as a result of limited buyers and export routes, Western leaders sanction Russia’s oil exports, or Russia voluntarily cuts off supply in response to Western sanctions.

Even without any supply troubles from Russia, the supply/demand balance had tightened, as high frequency data suggested global crude oil stockpiles were drawn down counter-seasonally in January and February. Among the key factors was OPEC+ (Organization of Petroleum Exporting Countries and select allies), which has so far struggled to meet its commitments to ramp up output. Diminishing Omicron variant fears and pent-up demand for travel staved off the typical winter seasonal drop in demand. Looking ahead, the International Energy Agency estimates oil consumption will rise from its present level of about 97 mb/d to 100 mb/d—a return to pre-COVID-19 levels by the end of the year, even before global aviation fully recovers.

US producers are also beginning to feel the effects of the inflationary environment via higher input costs. Typically, publicly traded oil companies would be ramping up output as rapidly as possible at the current price point. However, climate and shareholder activists have succeeded in forcing US and European fossil fuel producers to restrain their capital spending. US shale producers have yet to meaningfully boost their production in response to surging oil prices, signalling continued discipline with respect to capital spending and returns to shareholders, though in early March some indications surfaced to suggest management teams were beginning to consider reinvigorating their drilling activity and production growth.

Natural Gas

Russia is a key supplier of natural gas to Europe, and Ukraine is an established transit route for Russia’s gas shipments. The advent of war has sparked concerns that supply curtailments will get worse on the continent. Germany’s cancellation of the Nord Stream 2 pipeline’s certification has already put the Russian energy industry on notice, though Russia also just signed a 30-year contract to supply China via a new pipeline, boosting its energy alliance with Beijing. Nord Stream 2 was completed last year but had not received final certification, which appears unlikely now. The cancellation does not immediately affect gas supplies to Europe, since it would not have begun shipping until the second half of the year, but it does indicate that Russia’s biggest customer is willing to risk supply disruptions to punish Russia’s energy industry. Pipelines from Russia through Ukraine account for about 10% of all gas supply to the EU, and that supply is now at risk. LNG exports from both the United States and Qatar have helped narrow the supply deficit in Europe in recent months as the continent’s LNG imports moved to record highs, yet Europe-wide storage remained at a five-year low. US natural gas exports have reached a limit until new capacity comes online, and a fully integrated global market is still a long way off.

What’s Next?

The situation is dynamic, and as of this writing, Russian troops continue to lay siege to several Ukrainian cities. Sanctions have begun to impact the Russian economy and currency, the latter of which has lost significant value, as traders struggle to insure cargoes and shipping companies refuse to transport the country’s raw materials. Commodity prices have begun to reflect risk of disruption, which was strongly apparent in crude oil markets, where Brent prices have risen by more than US$20 per barrel (or 34%) since the invasion began, bringing the year-to-date increase to about 70% (through March 8).

Metals prices and palladium, in particular, have also experienced significant increases due to both supply disruptions and rising production costs, which in turn elevate marginal costs. These types of price spikes raise obvious questions about the durability of economic growth, a factor that we believe must be considered in the current environment.

Accurately predicting potential outcomes, applying market probabilities, and estimating the impact on commodity prices and related equities amid such a high level of uncertainty is a nearly impossible task. We therefore focus on what we know. Most commodities are trading above the marginal cost of supply and in some cases far above that baseline. In our estimation, natural resources equity valuations are not reflecting currently high spot commodity prices, but appear to be imputing prices that are also above marginal cost. While this situation in and of itself does not mean the stocks are overvalued, it does elevate the importance of cycle duration. Commodity prices typically revert to marginal cost—or lower—over time, and equity valuations should reflect excess profits generated during periods of high prices in addition to the discounted value of long-term normalised profits and terminal values (i.e., the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated).

Cycle duration in the current environment is obviously difficult to estimate, but we have written repeatedly about the lack of investment in new and existing resources and continue to believe this backdrop will result in a prolonged cycle of elevated prices. This is not to say that current prices will not retreat, which we believe is likely over the intermediate term, and natural resources equities may decline as a result. However, barring significant economic damage from the current Russia-Ukraine conflict and inflationary pressures, we think supply and demand balances should remain healthy for the next several years.

Given this outlook, we are seeking to reduce holdings in securities that have appreciated significantly and appear fair to fully valued. Uncertainty and volatility often lead to the mispricing of securities, both higher and lower than their intrinsic value, and so we are also focused on identifying attractive buying opportunities for our shareholders.

Performance across the energy sector’s seven industries has not been uniform lately, and we continue to find opportunities in the various sub-groups such as oilfield services and energy transportation infrastructure (e.g., pipeline operators).


 

Franklin Templeton Key risks & Disclaimers:

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton’s U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

What are the risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.



MeDirect Disclaimers:

This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

Share on facebook
Share on linkedin

Latest news articles

All News

BlackRock Commentary: Sour Fed growth view not dour enough

Many central banks, like the Fed, are still solely focused on pressure to quickly get core inflation back to 2% without fully acknowledging how much economic pain it will take in a world shaped by production constraints.

Notes from the Trading Desk - Franklin Templeton
All News

Notes from the Trading Desk – Franklin Templeton

The Federal Reserve (Fed), the Bank of England (BoE), the Swiss National Bank (SNB), Norges Bank and the Riksbank all raised interest rates last week and paved the way for further hikes at upcoming meetings.

All News

BlackRock Commentary: Sticking with reduced risk taking

Business activity is slumping and higher inflation persists. Central banks are responding with aggressive rate hikes without fully acknowledging the growth damage. The new regime of macro volatility is taking root with weaker growth, persistent inflation and volatile markets.

Experience better banking

The sooner you start managing your money, your way, using the best-in-class tools, the sooner you’ll see results. Sign up and open your account for free, within minutes.

Login

We strive to ensure a streamlined account opening process, via a structured and clear set of requirements and personalised assistance during the initial communication stages. If you are interested in opening a corporate account with MeDirect, please complete an Account Opening Information Questionnaire and send it to corporate@medirect.com.mt.

For a comprehensive list of documentation required to open a corporate account please contact us by email at corporate@medirect.com.mt or by phone on (+356) 2557 4444.