Investment strategy
November 2, 2022

OPEC’s ‘little fire’ is spreading

November 2, 2022
David Bailin
Chief Investment Officer and Head of Citi Global Wealth Investments
Steven Wieting
Chief Investment Strategist and Chief Economist
SUMMARY

Ongoing geopolitical risks and energy price spikes are driving the world to seek alternative sources. While a transition to clean energy is never going to abruptly eliminate historic fossil fuel sources, we see industrial firms that help make electrification a reality for consumers as secular winners in the years to come.


One of the geopolitical risks we’ve highlighted is the highly public conflict between the US administration and Organization of Petroleum Exporting Countries (OPEC) during the present period of intense risk for Russian oil exports. In October, OPEC decided to cut output quotas by 2 million barrels per day, even before reaching pre-COVID output levels.

Coupled with the US administration’s vow to buy domestic oil to refill the strategic petroleum reserve at a price averaging $70, this has put a floor under oil futures prices. The news puts the energy sector – typically one of the most cyclical – in an unusually good position to weather a demand shortfall if a recession hits.

The regional natural gas and oil picture diverged starkly this year as Russia’s piped gas to Europe suffered disruptions – perhaps permanently. This has improved the outlook for seaborn LNG dramatically. However, physical limits and seasonal demand variation highlight the industry’s high volatility.

Prices of natural gas futures in Europe have plunged as German physical storage capacity has been reached and inventories can’t rise further over the short term. The previous surge in natural gas costs has been perhaps the single largest driver of weakness for gas-importing regional currencies to date. A lasting turnaround in energy shortages could be consistent with a bottoming in bearish growth expectations for Europe.

With that said, the actual path of winter weather and the surge in gas demand that comes with it leave markets vulnerable to setbacks and further price shocks. As discussed in the October Quadrant, we’re not ready to declare an end to the vulnerability of Europe’s energy supplies.

An alternative offered by a very simple technology

The strong pricing for fossil fuels highlights the improving economics of alternatives, one of our Unstoppable Trends – the improvements in a very simple technology – heat pumps – which may provide a way for Europe to win significant energy independence from Russia.

A heat pump – because it moves heat rather than creates it – is not limited to 100% efficiency. Current-generation heat pumps are around 300% efficient, meaning it takes one-third the energy to heat a home compared to one with a completely efficient combustion-based heater. But there are already prototypes for next generation heat pumps that are as high as 500% efficient.

Given that half of all energy goes toward creating heat, a completed transition to next-generation heat pumps would mean a 40% reduction in total energy use, all else being equal. This transition will take a long time because it requires replacing heating systems in every building in the world – which is exactly why it’s an unstoppable trend and not a short-term trading opportunity.

But with governments around the world subsidizing heat pump installation and economics on the same side, the rate of adoption is increasing rapidly, albeit from a low starting level. We have seen other major transformations like this before, such as with LED light bulbs, which went from an expensive novelty to global staple.

Roughly half of all energy used globally is for heating. If home heating migrates to a new form of “electrification,” it will free up conventional energy supplies such as natural gas for industrial and agricultural uses. We see industrial firms that help make electrification a reality for consumers as secular winners in the years to come.

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