Market Musings 19/03/22:
What if oil prices hit $200?

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Weekly Summary:

Could oil prices really hit $200? What could drive them there?
Would higher oil prices guarantee a global recession?
The IEA’s 10 emergency proposals to reduce global oil demand
What does this mean for alternative energy sources?
Potential investment opportunities in energy

1. Could oil prices really hit $200?

In a recent Odd Lots podcast from Bloomberg, oil hedge fund manager Pierre Andurand suggested a path for crude oil to get to $200 by the end of the year, as historically tight markets struggle to ramp up production and replace lost supply from Russia.

Even if Russia and Ukraine were to agree to a ceasefire right now, Russian oil would not return to international markets in the near term, according to Andurand.

“I don’t think that suddenly they stop fighting, the oil comes back. It’s not going to be the case. The oil’s going to be gone for good”

“We’ll have to live with higher prices to keep demand down, for it to be treated a bit more as a luxury product and also to accelerate the energy transition”

“I feel like there’s no demand destruction at $110 a barrel and we’ll have to go significantly higher before demand can go down by enough”

My first observation is the obvious caveat: one should beware investors who are clearly talking their own book. Andurand’s hedge fund is reputed to have already made a huge return year to date from the surge in oil prices, so he is likely still very long in terms of positioning on crude oil.

But now that I have stated the obvious, let’s examine his assertion.

Even with a modest pullback in the Brent crude oil benchmark price from the $139/barrel high hit on 7 March, oil prices remain a long way above the 2000-2022 average of $65.…

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Ponzy Mad-Hoff

19th Mar '22

I reckon oil prices may surprise to the downside. The USA is the ultimate guarantor of security for swing producers like Saudi & UAE and could apply a lot more pressure to open the taps. A deal with Iran and possibly Venezuala seems on the cards so more supply may come online from them. India China and others will continue or even increase their import share of Russian oil so that would mean less demand on non Russian oil. Rising interest rates and inflation in western countries means a consumer squeeze and less demand for foreign travel and manufactured goods again reducing oil demand. There will be significant policy pressure led by US & Europe to keep the price down as it deprives Putin of income.

jwebster

21st Mar '22

There's a few options to bring the oil price to the down side.

Russia continues to ship oil to China etc, at a discount

US shale increases output, they can do this with extra rigs

A deal with Iran

Pentago

I believe the chronic under investment (outside the US) we have seen in oil industry project commencements since the 2014 oil price crash means that the spare capacity figures the IEA holds for Saudi and Iran are very unlikely to be sustainable. Higher prices are likely to persist, unless they drive the world into recession. The wild card is whether the US shale producers can retain the new-found capital discipline that is currently being rewarded by shareholders, or will the US administration push for greater reinvestment in return for holding off on super-profit taxation. I could be wrong on Saudi, if they were to reduce domestic consumption further, but that is proving difficult as domestic pricing is so low.

The current unwinding of globalisation and price volatility may introduce more opportunities in the downstream. The UK oil majors still look significantly undervalued in these scenarios, even with the forced sale of Russian businesses and lower returns on renewable energy investments.

Alphaflight

Oil/gas are likely to remain expensive (ex another lockdown that is).

....meanwhile most of the drilling companies, geophysics and other oil/gas exploration related companies are still stupidly cheap. Unless the world isn't going to look for more oil, these companies have to be repriced upwards at some point.

Snowbum

Petrofac (LON:PFC) looking appealing just now, price floor appears to have been set at 100p.

SFO investigation is now over resulting in the ban on tendering for work in the Middle East being lifted and the Saudis just announced an investment plan…

I have taken a starter position in my SIPP.

Thanks Forbsy this is now on my RADAR. I'll investigate it.

mojomogoz

Oil is complex and I'm not going to claim assured foresight on what happens here re price. Rather here are some thoughts on current and potential dynamics:

Russian fields are quite old and historically had poor maintenance until western majors and oil service cos got involved post USSR collapse. Production died after the collapse and it took best part of two decades to get it back up to pre collapse levels. Location and terrain are real problems (nearly inaccessible when not frozen due to bogs etc).
Russia nor China have the expertise to maintain/develop these fields without western input
The withdrawal of western cos (somewhat a surprise in excess of sanctions) may prove a death knell for Russian O&G
Oil has not yet touched a new record in USD terms but for many countries it is a new record due to dollar strength in the interim period -> eg GBP and YEN, but more importantly most emerging currencies. So for significant parts of world oil already seen new highs. As for gas its gone way through old highs in many countries.
The ability to accommodate high oil prices is complex and not static. Clearly the oil/energy intensity of economies counts. So that's a positive for developed nations where even aside from the issue of outsourced production economies have moved towards greater energy efficiency/productivity compared with decades ago (many people throwing 70s shade on this issue - I believe that is misplaced). This is particularly true in major industrial areas like Europe, Japan, SK where combo of actual price and policy driven expense has had massive impact.
Another issue IMO that gets no coverage is investment and credit creation cycles that clearly relate to growth cycles particularly in EMs and economies less powered by consumption than UK and US (so near everywhere else!). In 2008 we were on the back of a mega investment and credit cycle way beyond US subprime (a tiny iniquity by comparison that got a lot of coverage). That cycle of growing and layering activity made it possible for many economies to cope with high prices...as did the relative weakness of USD. This is not the situation today. USD is high and economies coming off a weak footing...that would be the case without covid and is more the cause due to it. There is no meaningful global credit engine and definitely a lack of willingness to point it to adventurous places.
This means that many parts of the world are in an acute bind with high oil prices and cannot cope nearly as well as before (and its important to factor in the massive impact this has on basic food needs to...after all the Arab Spring was brought about oil feeding into food poverty). Many parts of the world population, particularly those less affluent and less energy efficient/productive will see catastrophic demand destruction as prices remain elevated.
EM could be non-investable and EM crises rapidly appear and be widespread. This may prove quite surprising in that China could be precarious in this situation. Not as melodramatic as a collapse/crisis but China has been struggling with extensive malinvestment and bad debts in its now massive domestic infrastructure and real estate markets. It is also exposed to many EM countries through 'Belt and Road' with projects and financing that were already proving onerous. The good and highly productive part of the Chinese economy is its export capability...expect all to be done to maintain and bolster that relative to other areas if energy prices really bite.
Its likely that those that can access Russian resources (China?) will get themselves large and increasing discounts.

What does this all mean?

IMO the potential for demand destruction rapidly on high prices is huge. I cannot tell you the price. But I'm certain that $200 per barrel is only fleetingly possible. I'd guess an average price well below past $150 peak for a sustained period (so handwaving lets call it c.$130) is enough to begin massive demand destruction. A bit in US and Europe...but massively elsewhere.

Clearly this is meeting supply destruction (Russia and lack of investment elsewhere due to shunning of hydrocarbons plus oil cos learning a tough lesson re oversupply in the 2010s). But demand destruction will win out and as prices go higher the deterioration of weak countries accelerates. Clearly, the 'cost of living crisis' is a problem in UK too and it will kill demand but overall we will be able to struggle through this more and longer than other places...so those other places will lead demand destruction.

Investing in hydrocarbons is tricky from here. Its easy to say buy now as they will go higher. But expect prices of companies to contain a discount for commodity volatility too such that a stable price at $100 might be better than one that swings between $75 and $200. Locking in such prices will be very hard. The price is driven by the marginal barrel and it could be quite thin and fleeting.

On balance, I expect prices for these companies to average higher from here but it could be quite a volatile grind rather than rocket expected by many. And given that speculative money is definitely in the downdrafts could be eviscerating and hard for people to cope with. Nice dividends can likely be found.

There's also likely to be growing political pressure and incentives for new production and development. I'm not going to speculate on what that can be or the likelihood other than point out that the realisation of the absolute necessity of reliable energy supply could create direct and indirect confiscatory risk of various types (including on people who hold the investments).

Overall, I think that volatility in the price is going to surprise more than the highest level.

For me risk management is about finding investments that have durability even if they hit problems. For that reason, I find hydrocarbons a difficult risk at this point. My preference in nuclear and I invest in a broad basket of uranium related things. Very high risk as in deep capital cycle decline but my belief is that there is real duration and growth to the need for nuke. Enviro sorts or those deluded into the idea that renewables are cheaper (total system cost much higher...its just not priced due to policy and subsidy) that believe we can have anything approaching net zero without nuke are dangerous fools.

(That was longer than expected so may post separately too)