Marc Chandler mentioned in the last post that there has been some chatter about the Trump Administration tapping the US Strategic Petroleum Reserve supply to get oil prices down. Oil is an important issue as we head toward the end of this business cycle. And I want to put it into the context of secular supply-demand balance issues.
The SPR conundrum
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Here’s what Marc wrote about the SPR:
It is clear from Trump’s tweets that the high price of oil and gasoline is on his radar screen. He has harangued OPEC, though the immediate boost to oil prices seems to at least be partly related to geopolitical developments in which the US plays an important role, such as potential loss of Iranian output, the collapse of the Venezuelan economy, and the civil war in Libya. Poor investment decisions, corruption, and other local homegrown problems also bear significant responsibility.
Reports suggest at least three possible strategies are under consideration, but a decision may not imminent. It may take some time for the Administration to conclude that neither OPEC nor non-OPEC countries are going to boost output much more than has already been agreed. That is to say, despite the US encouragement, defections from OPEC/non-OPEC are unlikely. There has been some suggestion that a further 10% rise in oil or gasoline prices could serve as the trigger.
The three strategies include a small token release to send a signal and impact psychology, a larger draw to have a material impact, and an effort coordinated with other countries, as took place most recently during the “Arab Spring” in 2011. The latter may be the most effective and would flummox those that are mourning the passing of globalization. A release of US strategic holdings could also be used to coax other countries into participating in the embargo of Iranian oil starting in early November.
There are two considerations here: one is economic and the other is geopolitical.
On the economic side, the SPR plays a tactical role because of the increasing price of oil and the potential for demand destruction. I see Trump as a tactician more than a long-term strategist. So, using the Strategic Petroleum Reserve to provide modest price relief to consumers is something I could see him doing. This is especially true given the upcoming mid-term election.
Geopolitically, an SPR release also makes sense tactically if Trump wants to apply pressure on OPEC and other oil producers. And it could be used as a threat to get countries onside with Trump’s policy against Iran.
The economics of oil demand and capital expenditure
The shale oil bust brought the economics of high oil prices into question. Beforehand, the prevailing view had been that high oil prices were bad because it pinched consumer spending power, thus slowing the economy. But when the shale bust occurred, we witnessed the perils of low oil prices via the loss of significant capital investment and jobs.
So I think we need to be worried about both extremes, extremely low oil prices and extremely high oil prices. Judging when oil prices are extremely low or extremely high is more art than science. But clearly, the giveaway on the high side is faltering consumer demand. And the giveaway on the low side is capital expenditure cuts and layoffs.
Right now, we are nowhere near either of these situations. In some ways, you could call this a Goldilocks period – prices high enough to bolster capital expenditure but not high enough to crimp consumption.
So an SPR release is premature in my view. But, for political reasons, it might be what we see from the Trump Administration.
What about peak oil?
With oil prices climbing again, I think it’s natural to question the secular supply-demand balance narrative. A reader sent me an article on peak oil that I found a good read that I want to use as a jumping off point here. The question in the title: “Is the oil industry repeating a critical error” in ramping up capital expenditure?
Here’s how the article addresses it:
Oil prices started 2002 at around $20 per barrel and then rose almost continuously until mid-2008. As they rose, the world’s best known critic of peak oil prognostications, Daniel Yergin, began to look so foolish for having predicted ample supplies for decades to come that his firm finally reversed itself in mid-2008 and began to forecast higher prices. That should have been read as a contrarian signal; just two months later the oil bull market ended.
Peak oil thinkers at the time believed that their forecast of a nearby all-time peak in the rate of world oil production had been fulfilled…
But…
here is what peak oil thinkers couldn’t foresee: That investors would subsidize the production of vast amounts of oil rather than seeking a return on their capital and that they would do this year after year even in the face of the obvious financial evidence. Essentially, Wall Street has been subsidizing the consumption of oil on Main Street.
That this is unsustainable is obvious. Eventually, investors will realize that there is no long-term value in tight oil. For now, the flood of oil from tight oil formations has conjured the illusion that the world needn’t worry about oil supplies anymore because of the “miracle” of hydraulic fracturing, often referred to as fracking.
My view on peak oil
There is long-term value in tight oil. That’s my view. If the price of oil is high enough, then companies will want to extract shale oil. Sure, it is a speculative endeavour now. But oil drilling is all about speculation — booms and busts. That’s the nature of the business. In fact, if peak oil theory is partially right, then eventually more and more of this shale oil can be profitably extracted. We’re not there yet. But we will be there eventually.
Back about two decades ago, I started to invest in a company called Valero Energy. And it was a very profitable investment because Valero was an oil refiner, the most unsexy of businesses. No new refinery had been built in the US in years. And the supply of light sweet crude was dwindling. Valero’s appeal was the complexity of its refineries.
Valero CEO Bill Greehey bought refineries from oil majors that were more concentrated on upstream operations and upgraded them to be able to refine heavy sour crude. As ‘Peak Oil’ took over, the discount of heavy sour crude to light sweet increased dramatically since no one could refine the stuff. Valero and other independent refiners like Tesoro and Premcor made a killing.
So it’s not the ‘end of oil’ that we have to worry about. It is the end of cheap oil. And when cheap oil starts to become short of supply, sour and heavy discounts increase. Eventually, the increase in demand for oil becomes great enough that oil prices more generally rise significantly. That’s where we are now.
Oil and the Goldilocks economy
And since oil is a commodity business, these guys know that they need to pump out as much oil now as possible to benefit. Capex and employment in the oil patch rise with the prices and a boom ensues. Eventually though, because of the boom-bust cycle in oil and because of the business cycle, supply will vastly outstrip demand – even if peak oil theory holds. And a bust will kick in.
Right now, we’re in the Goldilocks phase of the boom era. The whole oil ecosystem is booming. Rents in the oil patch, for example, are the fastest rising in the entire US. Rents in West Texas rose more than 35% in the year to June as output in the Permian Basin rose to a record.
Source: Bloomberg
That’s crazy inflation. And so, those towns are booming.
But all good things must come to an end. If the global economy turns over the next 12-24 months as I suspect it will, the oil patch will see a significant bust. And oil prices will plummet, peak oil theory or not. We’re not there yet. But I believe it’s coming in 2019.
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