My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Oil update: prices skyrocket

Chronic underperformance by OPEC+ in meeting its output targets and rising geopolitical tensions have propelled oil prices higher. Benchmark crude prices rose by more than 15% in January to cross the $90/bbl threshold for the first time in more than seven years. Global oil stocks at multi-year lows and dwindling OPEC+ spare capacity have left the market with only a small cushion. – IEA Oil Market Report, February 2022

 

I wrote a fairly extensive article in E-MorningCoffee about oil in April 2020, which you can find here: “Texas Tea” (Oil). At the time I wrote that article, global demand had fallen off a cliff, plummeting around 15 million barrels / day because of self-imposed economic shutdowns related to COVID-19. This, in turn, caused oil prices to collapse, even going negative on one day (for WTI crude). Needless to say, things have changed quite a bit since then, as a confluence of factors have pushed the price of oil back up to levels not seen since mid-2014. I thought it would be interesting to provide an update as to where we stand at the moment, as well as to examine the dynamics that have caused this. If you would like more background on oil before diving into this article, you can go back and read the original article in E-MorningCoffee referenced above.


The trajectory of oil prices


With oil approaching $100/bbl now, it is hard to imagine that – less than two years ago – demand and supply were so out of line that WTI crude oil prices actually went negative for a day (April 20th). The sharp decline in oil prices at the onset of the pandemic and the steady recovery since then have of course been pandemic-driven. As global economies shut down to combat COVID-19 in 2Q2020, the world suddenly found it had excess supply of around 15 million barrels / day (15% or so of total global demand). It was only after global oil producers revised their production quotas down sharply that prices started to stabilise, and then eventually rise. Concurrently, demand began to recover albeit sporadically because of the erratic economic recovery related to several waves of COVID-19 variants that have appeared along the way. To give you a sense of oil price migration over the last couple of years, below is a graph from FRED that illustrates the price of WTI crude (US) and Brent (Europe/global) since the beginning of 2020.



Ignoring the bizarre one-day move to negative prices for WTI on April 20th 2020, the price of WTI crude bottomed at $8.91/bbl on April 21, 2020, the same day that Brent bottomed at $9.12/bbl. Since then, oil prices have been on a steady march higher although prices stalled in the second half of last year, only to resume their climb in 2022. The table to the right illustrates end-of-quarter oil prices throughout the pandemic period, starting at the end of 2019.

Drivers of increases in oil prices


Why have oil prices increased so much, especially recently, even as OPEC+ has been steadily increasing its production quotas? I will highlight three major reasons although there might be more.


Firstly, demand for oil began to recover slowly in late spring 2020 as many economies emerged from a complete two-month shutdown. However, the recovery in demand has remained somewhat sporadic because of several waves of variants that have led to “on-again, off-again” travel restrictions in various formats and levels of severity. The Omicron variant this past December and January proved to be widespread and extremely contagious, albeit mild, and passed relatively quickly. Omicron inevitably assisted – along with improving vaccination rates – the move towards broad immunity which has enabled economies to gradually return to normal. As restrictions have been lifted one after another, demand for oil has increased sharply as travel has increased and people have returned to (in-office) work, trends that have been gaining steam this year.


Secondly, some OPEC+ producers are having trouble meeting their monthly production quotas. The graph below from S&P Global Platts illustrates the shortfalls of OPEC+ as far as actual production versus quotas since the beginning of 2021.

Why are producers unable to meet their supply quotas? Two of the major reasons are underinvestment in infrastructure over the years (a long-term issue) and supply-chain disruptions that have left some producers short of materials needed to meet their production quotas (a short-term issue). According to the S&P Global Platts (here), 14 of 18 producers failed to meet their production quotas in January 2022. OPEC+ accounts for around 40% or so of the world’s supply of oil, so there is also the matter of the other 60% of supply that comes from non-OPEC+ countries like the US, the world’s largest producer.


The third reason that oil supplies have not increased in line with demand is because US production has been hesitant to fully come back on-stream, even with oil prices surging. Many US producers with high lifting costs have not resumed marginal production even though oil prices have risen sharply. Recall that the US was energy-independent prior to the pandemic, meaning that the US had actually become both the world’s largest producer of oil and a significant exporter of oil. However, the pressure on independents / smaller E&P companies, of which a significant number were probably shale producers, intensified during the pandemic as oil prices fell, leading to a reduction in supply and investment, or – in some cases – failure of energy companies. According to data in Statista.com, 66 US E&P companies have filed bankruptcy since the beginning of 2020. Many independent producers recall the last cyclical decrease in oil prices (mid-2013 to early 2016), when investors punished companies that had over-invested based on high oil prices. Shale companies have learnt that investors reward them for returning cash as opposed to (over)investing in new production / infrastructure. As a result, even though the price of oil is very attractive at the moment, many US shale producers have been reluctant to increase supply because of the inevitable “boom-bust” cycle of oil. There was a very good article about this very point recently in the FT, if you can access it: “Oil’s climb towards $100 a barrel tempts US shale companies to shed restraint”.


Aside from these three trends, we also have the issue of what is happening at the moment in Russia, as President Putin has declared independence for two eastern Ukrainian separatist regions and has now –apparently just this morning – launched a full-scale invasion of Ukraine. This triggered an initial round of sanctions, with more likely in reserve, that could reduce or even block Russia’s ability to export oil and gas. Russia is the world’s largest producer of natural gas and the second largest exporter of oil in the world (5m bbls/day), much of which goes to Europe. It is hard to say exactly how much of the increase in oil prices reflects the current situation in Ukraine, and how much reflects an even worse-case scenario in the coming days or weeks.


Have investors in energy companies been rewarded?


Investors in oil & gas companies, both major and independents, have done very well since pandemic lows, but especially since the end of 2020. The benchmark ETF for oil & gas companies is the State Street Energy Select Sector ETF (“XLE”), and you can find details for this benchmark ETF on the State Street website here. Exxon Mobile and Chevron account for just under 44% of the XLE’s 21 holdings, and the XLE currently makes up 8.8% of the S&P 500 SPDR index (“SPY”). Below is a graph of the price performance of the XLE since the beginning of 2020, compared to the performance of the S&P 500 (SPY ETF).

The XLE ETF has seen its price increase by 46.7% in the last year and offers a 30-day SEC yield of 3.17%. Its forward P/E, according to the ETF website, is 12.3x, which is very attractive to say the least. Having said all this, XLE has traditionally been an underperformer vis-a-vis the overall S&P 500 index. Over the last 5 years and 10 years, the return on the XLE has been negative over both periods. Even over the last 20 years, the return on the XLE has been positive but substantially below the return on the S&P 500.

Influence of ESG


There are several shades of how investors and activists view oil and other carbon-producing companies (like coal) as far as ESG initiatives, as the world strives to move towards carbon-neutral in the coming years. There are some investors that simply will not purchase the bonds or common stocks of fossil fuel companies, and some banks that have similarly cut-off lending completely to these companies. This is a noble approach and reflects the view that fossil fuel companies should not have access to capital in any form to further investment in the production of “dirty” fuels like oil and coal. However, it seems to me that this view is slowly being marginalised, not because the majority of investors don’t want to reduce the carbon footprint of the world, but rather because there is a recognition that investors can be more influential in the transition of traditional fossil fuel companies to the new world of clean energy by becoming activists, assisting and encouraging management teams as they develop and implement plants to transition to clean energy. Although this is the reality is that many developing countries are in much more difficult positions than developed countries because they have neither the resources nor the expertise to transition their economies to carbon-neutral in as short a period as many ESG activists desire. We can all have noble goals, but we also need to be realists because oil will not disappear overnight no matter what we might aspire to.


How much does petrol (i.e. gasoline) currently cost “at the pump” in the US, UK and France?


European governments impose significantly higher fuel taxes on both gasoline and diesel fuel than the US government. As a result, European drivers pay substantially more for gasoline than US drivers because of higher duty and sales tax / VAT on fuel. The table below compares prices of petrol by the gallon (more customary in the US) and litre (more customary in Europe) in the US, UK and France.

In the US, the wide percentage range for taxes (bottom row) is caused by the variation in excise taxes from state to state, on top of a fixed federal excise tax. Of course, it’s not just petrol prices that have been increasing, Natural gas prices, used for heating and cooking, have also been increasing and remain under pressure, especially in Europe.


 

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