It may be no coincidence that one of my favourite books is called “The Catastrophist” by Ronan Bennet. A catastrophist doesn’t just see the glass half-empty, but empty and broken with shards spelling impending pain and blood… I think this general world-view probably stood me in good stead as a bank-engineer assessing debt deals. What could possibly go wrong? well according to me, a lot, and with hindsight its amazing we did any deals at all.
The first problem with oil prices is that they are never stable – so the “lower forever” banking tag line is about as good as “this time it’s different’, which has never worked as an investment thesis. The second problem is that low oil prices trash our industry. The third problem is that high oil prices trash our industry. And of course the forth problem is that low prices lead to high oil prices (see problem 1, above). This post is (or will be after a brief intermission) about high oil prices. Be careful what you wish for.
I wonder whether this is due to my age, or rather my “vintage”, as a child of the 1970s. Britain was bleak and broken, in post-industrial decline, I was not directly affected, but in the extreme opposite of Milan Kundera’s classic “The Uunberable Lighness of Being“, this period was almost designed to traumatize – the unbearable heaviness of existence was brain fodder. I recall school lessons about the impending Ice Age (ironic given today’s consensus view, but actually reasonable when looking at natural cyclicity), the end of jobs (again a certain irony today), an essay project on the “last blade of grass left”, not to mention fun “public information” films (“PIFs”) and ads that ranged from children dying on farms (Apache), on railways “The Finishing Line” in gory bloody detail, and of course the “put you hands over your head and kiss your a** goodbye” in the “Protect and Survive” cold-war nuclear apocalyptic vision where clever use of string, canned food and a good attitude would see you through. For some reason it was always Sheffield that got fried – I never really worked that one out.
As the cold war receded we had been through huge industrial unrest as the fabric of post-war society changed, high inflation and interest rates (remember those?), race riots (“Is Brixton Burning?“), the nuclear Armageddon threat, and just when you thought it couldn’t get much worse, our generation’s “coming-of-age movie” was the 2001-Space Odyssey remake (ie another PIF) with a large obelisk emblazoned with “AIDS” and a blunt message about sex and certain death. Oh to be a Millennial, where the main concern is FOMO, and not enough likes on Instagram.
So what does this have to do with the oil price? Well, it’s just my view, and I thought it best to frame it with some background on my “catastrophist” world view since it gets quite bleak…
Why is energy important?
To paraphrase Nate Hagens, money is a just a proxy for, or future claim on, energy. Money doesn’t make the world go round, energy does; and oil is a fundamental part of the energy mix, being highly energy dense as well as being conveniently transportable and usable. The availability of cheap and abundant energy has underpinned the massive global expansion in the last 100 years, (although there are some who argue that there is now a “decoupling” of this relationship due to technology).
But technology is not energy. Energy prices have fluctuated, but not significantly changed throughout this period.
High Oil Prices
To my mind high oil prices are now inevitable. What is high? $100, $150, $200, $500 ? These numbers seem improbable as they extend outside of our experience – but that is not a reason to say “impossible”. Let me explain.
As I have discussed in previous posts oil is seriously undervalued in our society, and the current zeitgeist on renewables and technology are creating willful blindness on the impending oil shortage. This is not classic “peak-oil” which theorized that we were running out of oil, but rather the “peak-cheap-oil“, which says that we are well past the peak of cheap oil and that here-forwards everything is more expensive. The US shale revolution has disguised this cleverly for a while, but the unrelenting cash injections and accounting smoke and mirrors seems to confirm that unconventional=expensive, and its not a long-term panacea.
In the meantime, conventional oil is the unloved child – with capital spurning everything from maintenance to exploration, existing fields will deplete more quickly than anticipated and new fields are (a) not being found and (b) not being developed if found and (c) are just not of scale. Recent low oil prices have likely been the cause of demand exceeding expectations (we have reportedly passed 100mmbbl/day recently, 10-15 years ahead of some projections). So with the risk of repeating myself from previous posts; a 6%-7% average annual decline (significantly higher than the historical guestimate of 3%-4% traditionally used) would take out some 18-20mmbbls/day within three years.
That is a very big gap to fill. Shale in the US cannot do this, at least not at prices anywhere near the recent range. With all the dollars, technology and resources thrown at the best US plays to-date, shale produces some 5-6mmbbls/day. Impressive, but not enough to plug this gap, and given that the current 5-6mmbbls/day is itself declining at much higher rates, the gap will actually require 10-15mmbbls/day of new production. Its really hard to see where this will come from in a short-cycle. Yes there are legacy projects that can be sanctioned and fast-tracked, but this industry is famous for its choke-chain roller-coaster behaviour. When prices are high we over-build, when low, we over-cut. So yes, a huge breakout in prices is ahead as this timing disconnect becomes manifest: “the Big Long” for those who, like me, are bullish.
This is really bad news.
Whilst we would like higher prices so we could go back to making money, much higher prices have a huge downside (or two). Firstly, whilst the world is still turning, high oil prices (rightly) spur substitution. This is a good thing except for the fact that there really is no energy equivalent alternative, which is a nice segue into point 2….
Secondly, and by far the most concerning, is that the cheapness of oil underpins the global economy as mentioned above. And I am not just talking about transport – but literally everything thing that we take for granted, from fresh produce in the supermarket, to overnight delivery, to water/electricity, most gadgets and (most) renewable energy. On the latter point, just think about the exploration for – and mining of – minerals, transportation, fabrication, transportation, installation and maintenance… if the cost of all those steps goes up because oil has got more expensive, so your solar panel/ wind turbine becomes more expensive – there may well be “parity”, but it will be at an increasing cost.
OPEC lost control in 2013
There is relief in many areas that OPEC (and some key non-OPEC players) has/have managed the over-supply and stabilized/supported prices. However, this, to my mind belies a harder truth. OPEC can respond to low prices by cutting, but can’t respond to high prices by increasing production in a meaningful way. This is in italics as it is critical given that politicians of all flavours (with one notable exception, and probably not for the right reasons…) believe in the fairy-tale that abundant cheap clean energy is just around the corner, so we can ignore supply concerns.
In 2010-2014 the world lived with historically high oil prices – the economic effect was largely masked by the unprecedented QE going on all over the world following the financial crisis: but fundamentally higher oil prices push up the cost of almost all goods, which in a normal world would have fueled inflation. It was widely recognized that oil prices over 100$/bbl would drive substitution, so logically a cartel looking out for its best interests would have opened the taps and capped prices. Theoretically there was quite a bit of spare capacity…
With US LTO production climbing, such a policy would have had a rapid effect. As we all know, nothing of the sort happened.
Whilst it is clearly speculation, it is not inconceivable that there was not sufficient easy spare capacity to simply “open the taps” – and as such the invisible hand of the market kept prices high, until a combination of increasing supply and geopolitics slapped them back down. Whether this theory is correct or not is perhaps a red-herring; as the total excess capacity currently held today, whilst not known exactly, is thought to be very thin.
Consequently, if oil prices spike in the next couple of years, as the world wakes up to the fact that “peak-demand” is a nice idea but not a current reality, security of supply has been ignored by the political and finance community, and OPEC can’t come riding to the rescue, the price spike will only go higher; and as we know that is a bad thing.
You don’t have to look back very far to see the effect of an oil-price spike combined with a gigantic debt problem – 2008 and the financial crisis. That was blamed on the sub-prime and poorly regulated banks… but not just. High commodity prices played their part; just prior to the banking crisis, oil hit 147$/bbl. A coincidence maybe.
So what happens when the debt pile is significantly bigger, stock markets are irrationally high, the oil price spike bigger, and there is (virtually) no room to pull financial and monetary levers (since they are all fully engaged) ? Inflation, bankruptcies, global recession? (BTW, did I mention that I am a catastrophist by nature?)
If you think the above is fanciful, this will be pure fiction and you can have a good laugh. However, if there is a thread of truth, we should be thinking about a radical change in “global” policy. The global management of a remaining resource, so that good stewardship can use remaining cheap(ish) oil to fund/subsidize the transition to renewables as much as possible, and wean us off of plastics as a way of preserving the GDP/energy balance. We don’t want high oil prices any more than we want low ones, stability would be a Utopian vision to help transition… This would of course require cooperation on a global scale, or extreme isolationism of those “with” the resources. The former has no historical precedent, the latter wouldn’t create stability(!)… I’m not overly optimistic on this one…
And for a very UK-centric view, the government should stop fretting over Brexit and cabinet re-shuffles (deckchairs, anyone?) and make some new Public Information Films about how 65 million people can exist on a small island with virtually no oil, no currency to buy it with, and with inadequate food production entirely dependent on hydrocarbons and their by-products. Maybe now is the time to be scared?