While the spotlight in the market has moved away from oil as the near-term inflationary impact of the sector has subsided and global supply seems to be ample from both a liquids and product perspective, there is a structural shift in the progression of energy cycles that is increasingly misunderstood by the market.

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Commentaries have focused on the day to day, including Organization of the Petroleum Exporting Countries (OPEC) press releases, United States Energy Information Administration (EIA) inventory numbers or the latest Houthi missile attacks in the Red Sea, but the big theme that will be key in driving valuations sustainably higher versus prior energy cycles is a significantly quicker supply response from either policymakers or oil producers.

Saudi Arabian Oil Co. has historically played a pivotal role in global oil supply balance, but recent OPEC decisions signal a potential easing of its influential “Saudi Put,” potentially boosting supply forecasts for the coming years. Despite oil price fluctuations, passive energy indexes have held firm near peak levels, suggesting confidence in long-term prospects despite short-term volatility.

Less discussed, but equally impactful is the potential “Iranian Put,” where renewed U.S. sanctions on Iranian oil could drastically alter supply dynamics, especially in the lead-up to the upcoming U.S. presidential election.

Former U.S. president Donald Trump highlighted this issue in a recent interview, emphasizing the need to enforce sanctions on Iranian oil exports, a move that could swiftly recalibrate global supply levels. The Iranian Put is very much in play and sanctioning the 1.8 millions of barrels of oil exports out of Iran would solve any sort of oversupply issue in one broad stroke.

Looking ahead, amid the wave of U.S. market consolidation and a heightened focus on capital discipline and shareholder return, the tipping point for U.S. shale producers to curtail capital expenditures likely begins around US$60 West Texas Intermediate.

This is still quite far from current levels in the US$70 range, but energy valuations this cycle should be higher than prior cycles given the price floor for U.S. unconventionals, whereas during the last cycle in the mid-2010s, that price floor was more uncertain given the different management incentive structures, with the focus on production growth versus free cash flow.

While there are many mechanisms at work that limit the downside for oil, the upside volatility is likely fairly muted for the commodity. Much of the geopolitical risk premium that investors are looking for is extremely short-lived, with the exception of COVID-19, though it only took about a year to recover to pre-pandemic levels.

The reality is that there are so many untapped oil and gas assets in the world: the United Arab Emirates alone has 100-plus years of inventory; North America has tons of oil and gas reserves, infrastructure issues aside; there are untapped low-cost reserves artificially suppressed in areas such as Kurdistan and Iran; and technology advancements with 3D seismics allow for deeper offshore oil assets to be recovered, as we’ve seen in areas such as Guyana and Namibia.

We believe the Goldilocks zone for oil is in the US$75-to-US$85 level for Brent, as companies are still able to generate significant cash flow while not risking real demand destruction, which inevitably occurs when oil prices are high (US$100-plus).

As the market increasingly prices in this steady state in oil, resulting in a reduction in volatility, valuation multiples for energy companies should also go up as investors are more willing to underwrite the full cycle of energy as opposed to what’s happening over the short term.

Jeremy Lin, portfolio manager of Purpose Global Resource Fund at Purpose Investments.

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