Why Oil Prices Will Continue to Rally in 2021

NYSE: USO | United States Oil Fund News, Ratings, and Charts

USO – Oil is at multiyear highs as it hovers around $75. Despite these gains, there is more upside as demand is strong, and companies are not increasing production or investing in new supply.

Like many assets, oil has had a stunning turnaround since the depths of the coronavirus. In April 2020 the front-month contract actually went negative as many traders were forced to sell at a loss to avoid taking delivery. Of course, demand was also collapsing due to the coronavirus, shutdowns, and restrictions in mobility in many parts of the world. It resulted in record inventories, and companies paying exorbitant amounts of money to store oil on tankers.

A little more than a year later, the situation is quite different, as oil prices are at multi-year highs with the front-month contract reaching $75 per barrel. This is evident with the United States Oil Fund (USO) which is up 193% from its lows during last spring. 

Inventories have been drawn down, while demand is nearly at pre-pandemic levels, despite continued COVID-19 restrictions in many parts of the world. If things continue to normalize and travel volumes continue improving, then demand is likely to continue growing. While demand has rebounded, supply has not rebounded. In fact, CAPEX in the energy sector has been low for many years due to the impact of shale production over the last decade. Based on the lack of new production and supply constraints, I believe that oil prices could reach new highs in the coming years. 

Supply Situation

Even though oil has had a healthy recovery, there is some skepticism that the rally will continue. This is evident from future-month contracts which are trading at a discount to front-month contracts. This is also reflected in the multiples of energy exploration and production companies which are trading at low multiples that only make sense if one expects energy prices to reverse lower.

It’s clear that many companies also believe in this narrative as CAPEX has not risen. In fact, over the past decade, energy prices have trended lower in part due to the massive supply that was unleashed following the previous bull market. Thus, management teams that have prioritized cash flow and reducing leverage have been rewarded, while those who aggressively invested in increasing capacity were punished. This is clear in the chart below-showing capital spending from oil & gas companies over the past decade.

However, this behavior is not changing in 2021 despite higher prices. Previous bull markets only ended when production began to improve and significant sums were invested in developing new sources of energy. Until we see such a response, I believe that investors should continue buying dips in energy stocks and commodities.

Demand Growing

So much of human history and progress has been about using energy in more efficient ways. Think about the first farmers who figured out they could use animal labor to plant more crops. This breakthrough laid the seeds for human civilization flourishing as it created time and resources for people to pursue education and other professions.

It remains true today as developing countries are consuming more energy as an increasing share of their population moves into the middle class. Moving into the middle class comes with buying refrigerators, air conditioning, owning a car, and eating more meat. All of these activities and behaviors lead to more energy consumption.

In 2008, there were an estimated 800 million people in the global middle class, this number is expected to reach between 2.5 billion and 3 billion by 2030. Thus, even with an increasing share of energy coming from renewables, total energy demand and consumption will be markedly higher.

Conclusion

Many investors are unenthusiastic about investing in energy due to the increasing share of renewables. However, there is currently a 30 to 50-year gap until renewables can displace fossil fuels in a significant manner.

This gap is setting up another bull market in energy that could go farther and last longer than the previous bull market which took oil to nearly $150 in 2008. I believe that oil prices will keep rising until we see a meaningful jump in Capex that unlocks new production.

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USO shares were trading at $50.47 per share on Friday afternoon, up $0.95 (+1.92%). Year-to-date, USO has gained 52.89%, versus a 17.05% rise in the benchmark S&P 500 index during the same period.


About the Author: Jaimini Desai


Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of POWR Growth newsletter. Learn more about Jaimini’s background, along with links to his most recent articles. More...


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