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Oil rally has legs
ETF Securities Commodities Research: Oil rally has legs
Summary
- Market balance can be achieved in 2016 as demand grows and supply declines.
- Many OPEC members are likely to cut back on supply. Iran is unlikely to raise production to pre-sanction levels.
- To meet future demand for oil, prices will have to rise further.
Toward market balance
Brent has risen to above US$43/bbl from below US$28/bbl in January as investor optimism for oil has markedly improved. We believe the gains in price are sustainable and not just driven by speculative gains.
Based on IEA’s demand forecasts, we are likely to be in a global oil supply deficit by Q3 2016, even if we assume that supply does not fall from Q1 2016 levels.
Supply however has been declining from non-OPEC sources. A large part of the decline in production has come from the US where the lagged effects of cuts in oil rigs in 2014 and 2015 are substantially biting into supply. By December 2015 global oil CAPEX was declining at a rate of 32% year-on-year. Although some large projects – too far into development to reverse – are still coming on-stream in countries like Brazil and Russia, most non-OPEC producing countries should see declining production.
Will OPEC supply also decline?
While OPEC has failed to coordinate to freeze production, except for Iran, most of its members are already cutting back on production and we expect a continuation of this trend.
Iran seeks to bring its production back to pre-sanction levels (3.7 million barrels per day) and so has increased its output from 2.8 million barrels per day in Q1 2015 to 3.3 million barrels per day in Q1 2016. But we think that Iran will struggle to raise production further than 3.5 million barrels per day by 2017, as it would require a significant infrastructure build, which will be difficult to achieve while sanctions are only part-lifted and oil prices remain relatively weak.
Under the strain of low oil prices, OPEC countries have been cutting back on fiscal expenditure. The current account of the Gulf Governing Council and Algeria is expected to reverse from a comfortable surplus to a deficit of about 8% of GDP in 2016. We believe it will be very difficult for OPEC countries to invest in any additional capacity that would allow for a significant increase in oil production under such conditions.
By 2017 OPEC spare capacity is likely to fall to 1.57 million barrels per day, down from 3.98 million barrels in 2010. With reduced spare capacity, unplanned outages will be difficult to deal with without spike in prices. Unplanned outages in Saudi Arabia and Kuwait appear to have been increasing lately.
Electricity outagesi, hyperinflation and forced worker holidays could see oil outages pick up in Venezuela too.
In its “Vision 2030” plan, Saudi Arabia has articulated that it wants it economy to be less reliant on oil. If the country follows through with its plans, the country may not seek to expand production capacity as aggressively as it has done in the past.
Inventory concerns overstated
US crude oil inventories have risen strongly since the collapse in oil prices in November 2014. However, with production declining in the US, we believe that constraints on storage will be alleviated. Storage is likely to have reached 70-80%ii of capacity in the US, but with the ability to export US oil and the development of storage capacity in other countries, we believe the market concerns around storing oi in the US are overstated.
China in particular has been investing in building storage capacity. China built 200 million barrels in strategic petroleum reserves (SPR) between 2006 and 2016. According to the IEA, in 2016 alone they will build 110 mb of SPR (and a further 35 mb of commercial).
Meeting future demand
Current global oil demand is approximately 95 million barrels per day and we believe that it could rise to 98 million barrels by 2020. Only 80 million barrels of this can be met by currently producing fields. To unlock the remaining 18, oil prices will have to increase. The break-even for tight oil for example is estimated to be US$65/bbl.iii
i Venezuela is highly reliant on hydroelectricity and low water-levels have led to shut-ins.
ii The last data release for storage capacity was as of September 2015. Since then more capacity has been built, but we will only get EIA data on this at the end of May 2016 for March 2016.
iii The line in the chart represents the weighted average break-even oil price i.e. the Brent oil price at which net-present value is zero using a real discount rate of 7.5%. The bands around the break-even represent the 60% confidence interval. Producing fields have a low break-even due to CAPEX already sunk and cheap Middle East oil.
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Donald Trump’s return to the White House has forced European leaders to reconsider their defence capabilities. Trump’s administration has stated that it expects European countries to take on a greater role in their own security, as well as giving overt signals that it has less interest in the future of the continent’s security. In a worst-case scenario, there are growing fears about the US’ continued commitment to the NATO alliance. This article will outline the scale of the task ahead for Europe to prepare for a world where it can potentially no longer rely on the US for its security.
Europe alone?
First, it is worth noting that the prospect of a US pullout of NATO remains unlikely. While members of Trump’s cabinet have endorsed a withdrawal, the president himself has not. Key members of Trump’s cabinet such as Secretary of State Marco Rubio appear to remain strong believers in the alliance. Crucially, in 2023, the US Congress passed a law requiring a two-thirds majority vote before any President can withdraw from the alliance. Given the current makeup of Congress, such a vote passing seems unlikely.
However, European leaders are taking the risk seriously. Even if the worst-case scenario of a total US withdrawal from NATO does not come to pass, the prospect can no longer be discounted. At the same time, even if the US continues as a member, there is a growing expectation of Europe to develop its own defence capabilities. There is, therefore, a renewed sense among European leaders that they must develop credible security deterrence in the absence of the US.
What is needed?
A recent analysis by Bruegel and the Kiel Institute for the World Economy provides insights into the measures Europe would need to undertake to deter potential aggression from Russia in the absence of US support. [1]
First, soldiers. Currently, the US has around 100,000 troops stationed on the continent, with NATO military planners assuming an additional 200,000 would be rapidly dispatched to Europe in the event of conflict.
A theoretical absence of US support, therefore, means considering how Europe may replace these 300,000 soldiers. Europe, including the UK, currently has almost 1.5 million active-duty military personnel. In theory, this makes replacing the 300,000 US troops easy enough. However, as analysis by Bruegel notes: “The combat power of 300,000 US troops is substantially greater than the equivalent number of European troops distributed over 29 national armies.”
A crucial weakness of European troops will be fragmentation. A Europe without US support, therefore, is faced with two choices: replace the 300,000 with substantially more soldiers – to offset the fragmented weakness – or rapidly enhance cooperation.
The challenge is also stark when it comes to equipment. The Bruegel analysis claims that preventing a rapid Russian breakthrough in the Baltic states would, at a minimum, require “1,400 tanks, 2,000 infantry fighting vehicles and 700 artillery pieces (155mm howitzers and multiple rocket launchers)”. To put this into perspective, that is more firepower than the French, German, Italian, and British land forces combined. And that is just for providing a credible deterrence in the Baltic states.
European states will also have to invest substantially in developing their own transport, missile, drone, communications, and intelligence capabilities.
Historic underspend
Future-proofing European defence against a potential absence of US support, therefore, is a tremendous task. Achieving anything approaching what is needed to shore up the continent’s defence will cost tremendous sums.
This has been made harder by the underspending on defence among European NATO members over the past few decades. The euphoria of the post-Cold War era saw European governments slash their defence spending. Money that had previously been spent on military security could be reallocated to spending on social security.
With Russia’s first invasion of Ukraine in 2014, NATO took steps to reverse this, principally by setting a defence spending target of 2% of GDP for members. But very few NATO members actually reached this target. As late as 2021, just 6 members of NATO spent 2% or more on defence.
However, as the graph below shows, the number of NATO members hitting the 2% target has rapidly ramped up, with 23 members now hitting the 2% target.
Source: NATO, June 2024. Data excludes the U.S. For illustrative purposes only. Chart displays expected data.
Yet the historic underspending by Europe leaves a hole in European defence capabilities. Figures from Exante Data shows that the cumulative underspend since 2014, relative to the 2% targets, among European NATO members equals €850bn. [2]
The road to 5%
The task for both readying Europe for defence challenges in a world without US support, as well as addressing the historic underfunding of European defence, will require defence spending rising significantly above 2% of GDP.
Currently, European (and Canada) NATO members spend, on average, around 2% of GDP on defence. If NATO ex-USA members were to increase defence spending to 5% of GDP, what would this look like? If certain assumptions are made, we can map out the bullish and bearish scenarios for NATO defence spending.
In our bull case scenario, we assume NATO ex-US defence budgets to increase to 5% of GDP by 2029, while assuming equipment spending as % of total NATO budget growing by 1% per year. It also includes assumptions of GDP growth per year standing at 2%.
In this scenario, equipment expenditure would increase by $350billion, over half the total revenue generated by defence companies in 2023.
Meanwhile, in our bear case scenario, equipment expenditure still grows by almost $100billion over the period. This bear case scenario assumes NATO ex-US defence budgets grow to 3.5% by 2029, with equipment expenditure remaining steady as a percentage of defence spending (31.6%) and GDP growth of 1% per year. This would see additional equipment expenditure increase by $92billion.
Source: NATO, HANetf analysis. Charts display projected data. For illustrative purposes only. Additional sources available upon request.
The Future of Defence
While the complete withdrawal of the US from NATO is a hypothetical scenario, these estimates underscore the significant investments and structural changes Europe would need to implement to maintain a credible defence posture independently.
Future of Defence UCITS ETF (ASWC) seeks to provide exposure to the companies generating revenue from NATO and NATO+ ally defence and cyber defence spending. The “NATO screen” seeks to align with the values of investors who may have concerns about defence investing, but cannot ignore the current political climate, and therefore seek a smarter and more considered approach.
NATO is a defensive alliance and itself states that “deterrence and defence is one of its core tasks” – focusing on companies operating in NATO allied countries limits the possibility of constituents of the ETF being companies operating in countries that could one day be adversaries to the alliance.
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Handla ASWC ETF
HANetf Future of Defence UCITS ETF (ASWC ETF) är en europeisk börshandlad fond. Denna fond handlas på flera olika börser, till exempel Deutsche Boerse Xetra och London Stock Exchange. Av den anledningen förekommer olika kortnamn på samma börshandlade fond.
Det betyder att det går att handla andelar i denna ETF genom de flesta svenska banker och Internetmäklare, till exempel DEGIRO, Nordnet, SAVR och Avanza.
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