Monday 1 November 2021
Upward pressure on oil prices has formed a powerful belief cloud, casting a spell over all discussions of demand. It’s been said no factor changes sentiment more effectively than price, and the current elevation of oil prices to 8 year highs is having a major impact on human psychology. The flurry of reactions are reminiscent of the previous decade’s bull market, when The Oil Drum ran frequent conjectures that Saudi Arabia had reached production limits. During this time, oil and gas equities were upwardly volatile, acting more like hot technology stocks. Echoes of these themes are now seen in doubts about OPEC spare capacity, and warnings that the multi-year downtrend in investment means the marginal barrel will not be developed in time to meet relentless global demand growth.
To be honest, this is all rather amusing if not a tad desperate. From 2002 to 2008 there was a very legitimate and ongoing supply side problem as global demand soared and production failed to grow for at least five straight years. This meant for an exciting, profitable, and sustained bull market in oil which trounced the views and expectations of the previous generation of analysts, who’d largely grown up in an era of oversupply. Today, you can feel the desire to run that script once more. And prices are cooperating, helping to drive the conversation forward as business media cannot help but run with the daily superlatives.
But this is how narratives always unfold in recoveries, as they ride a wave of ephemeral conditions. When prices move from the unusually low levels only seen during a crisis, and begin to normalize, it’s impossible to interpret that change as anything less than dramatic—and in particular, meaningful. But this is a form of losing one’s head, of being swept away on a magic carpet of giddy portent. You can see the same interpretations now surrounding inflation, copper, supply chains, and wages. But the greatest probability is that all these supply issues, and wages in particular, will eventually revert to longer-term trends. Is it wise to conclude that myriad longer-term trends have broken, simply because of the volatility set in motion by a global pandemic? The deflationary forces unleashed by technology are still very much with us. But, like the oil price, are currently held in suspension.
The oil and gas community however is very much in I-told-you-so mode, as they delight in the price spikes seen round the world. Much of this reaction comes from years of declining investment interest in the oil and gas sector, and the frustration that comes when growth dies. Indeed, before the pandemic, a broad sense of resignation was emerging among oil and gas investors. They saw EV coming, and they saw the trend to broader electrification. In particular, they understood very well that should oil prices ever spike again, it would likely accelerate consumer preferences towards EV. Real talk: I have attended oil conferences and investment meetings with Houston and Calgary based oil and gas executives and investors who routinely agree that the 2002-2008 bull market in oil did long term damage to oil demand growth. It’s called demand destruction. These dynamics are very well known not just among oil and gas investors, but among oil and gas operators and the industry.
But now a new narrative is taking hold, one that stitches together a bunch of disparate facts into a comically false timeline. The likely reason: a swarm of climate policy and clean energy technology is barreling down on oil faster than ever, and this temporary price spike is seen as a form of revenge. You can see that I-told-you-so narrative below, in a meme that’s been going around twitter.
The meme is admittedly clever. But it’s a reflection of the cloudy, evidence free thinking that occurs when people feel resentment. Some facts. North America has at least 2.6 million miles of existing oil and gas pipelines. The cancellation of the Keystone pipeline, for example, which was always and everywhere nothing but symbolic for both climate advocates and their opposition, has had precisely zero effect on the global price of oil this year, last year, or five years ago. More remarkable is that Joe Biden has been President for all of 9 months, while the four year Trump term was very much a deregulatory bonanza for resource extraction in the US. No president has recently or meaningfully discouraged investment in oil and gas. On the contrary, the largest one-time increase in US energy supply in fifty-years occurred under President Obama’s two terms, with US oil and gas production absolutely skyrocketing. It was the Obama administration also that kicked off the LNG export approval boom, starting in 2014. And here the ironies stack up in layers, because the industry desperately wanted LNG export capacity to unlock cheap natural gas, freeing it to ride much higher world pricing, and that is precisely what happened! Finally no central bank, including the Federal Reserve, went on an insane spending spree. Rather, a once in a century global pandemic triggered a massive monetary and fiscal response which did exactly what it was intended to do: revive economies faster, so that the world didn’t suffer another painfully slow economic recovery as last seen post 2008.
The only group that will be potentially hurt should they believe the current narrative are oil and gas investors. And here, we already know that these investors began to withdraw their interest and support from the sector years ago. And they did so for the oldest reason ever: because growth prospects turned sour. Accordingly, with climate policy on one side, new energy technology on another, and declining growth rates in fossil fuel demand to complete the picture, memes like the one above are now entirely political. Indeed, the political resentment expressed is very reminiscent of the wounded, aggrieved explanations for the long decline of other industries in various regions: steel, autos, mining. A prime example comes from the decline of the global nuclear industry, which continues to place blame on anti-nuclear activists for its long stagnation. But no anti-nuclear activism was required for the nuclear power industry to run into trouble. Rather, it was organized opposition from local communities, and a broad lack of interest among investors to put capital into the industry.
No wise investor is going to be tempted back into oil and gas, with global oil demand still sitting below the 2019 highs, given that OECD oil demand is finally ready to decline. Chemicals and Non-OECD demand may fill this global demand gap for a few years or more, but not enough to sustainably push total global demand to notably new highs. A colossal capex cycle meanwhile is underway in battery, EV, and new energy capacity construction. This is where the action can be found, and this is where investor activity will take place. Newsflash: investors love growth. Will there be fresh policy to come? Yes, no question. But the policy to come does not explain the past 5-7 years. The central political problem for communities that have built their livelihoods around coal, natural gas, and oil, is that new energy is winning the race.
The US is going to conduct its next round of climate policy through the tax code. By doing so, the US will go lightly on the suppression of fossil fuel demand, and go heavy on incentives for wind, solar, storage, transmission, EV, and EV charging networks. This uniquely American weighting of policy comes after internal Democratic Party opposition to most punitive or disincentives around oil and gas production, and emissions. While US Senators Sinema and Manchin are the most prominent opponents of such policies, and can fairly be credited with stripping out the biggest pieces of the Biden climate plan, the politics of fossil fuel demand suppression are not easy. Accordingly, the US is about to supersize the same approach it has used for well over a decade. This means that new wind, solar and storage will be built at an even faster pace, and fossil fuel consumption will get killed but in a way that appears organic, and best of all, in a way that makes it harder to place blame on any particular politician. Solar equities and domestic EV equities thrived this past week on both the rumors of the policy, and leaked details. While The Gregor Letter is not going to keep regular track of the market outcomes to such a policy, readers might enjoy comparing, from this point forward, the performance of XOP, the SPDR Oil and Gas ETF which concentrates on US names, with TAN, the Invesco Global Solar ETF. Better still: comparing the performance of those two ETFs since the Economist Cover of October 16, 2021, which declared a scary energy crisis was now upon the world. Boo! So scary!
OECD oil consumption has finally entered decline, after fifteen years on an oscillating plateau. The explanations are fairly obvious. Despite population growth, oil inputs to GDP have been in decline for some time, and now comes the electrification of transportation to extend that trend. Looking a bit more closely, the Great Recession took a big bite out of OECD demand and prevented consumption from ever returning to the old highs of 2005, just above 50 mbpd. However, the OECD got close: in 2019, demand did make its way back to nearly 48 mbpd. Now, as they say, oil has mostly lost the plot in developed nations.
In the chart below, the EIA is forecasting that yes, OECD oil very obviously rebounds from the lows of last year, but still comes up well short of the 2019 highs, only making its way back to 45.72 mbpd next year. As Oil Fall projected back in 2018: by the time the next automobile cycle got going, around 2021 or 2022, it was going to be too late for oil. This particular concept should be fairly obvious now: EV adoption has bolted towards 20% market share in Europe, and the EV wave is about to begin in earnest in the US.
Now ask yourself: will the Non-OECD continue to grow demand enough to counteract OECD declines? That’s mostly been the story of the past decade. More accurately, Non-OECD growth has so far counteracted the OECD demand plateau. But can it fight outright declines? That will be much harder. | Data set in Excel form available here.
In addition to revving up the solar names, the proposed Biden reconciliation bill also juiced the EV sector. Shares of Ford Motor Company jumped last week, not only on a good earnings report and outlook but in the shadow of looming EV incentive features that may be signed into law as early as next week. US political culture has increasingly asked for a more robust industrial policy. Well, now we’re going to get one. The Biden bill would unashamedly favor US manufactured EV, and would add an extra tax rebate for EV built with union labor. The initial terms are broad, however, and start with a refreshed $7,500 federal tax credit that would apply to all automakers domestic and foreign for the next five years (including Tesla, which “ran out” of its federal credits some time ago) regardless of where or how the EV is made. During this time, vehicles stamped out by US union labor would get an additional $4,500 kicker rebate, as well. But after five years, the credits are withdrawn entirely for EV not made in the US. The incentives are pared back for very high end luxury cars too, of course, but will easily apply to something like the new Ford F-150 Lightning EV truck. $12,000 worth of federal rebates is a big deal, and comes just as the US is about to join the rest of the world in offering an excellent menu of EV offerings. This policy also comes at a time when many in the oil and gas sector are certain a multi-year oil supply-demand crunch is upon us. Woops. :-) Nota bene: these rebate figures are moving around as the bill comes together, so while the general contours are roughly right, please follow the newsflow until the final bill is actually passed into law.
European natural gas prices fell hard from recent nosebleed levels, as Russia’s Putin made noise about getting more supply to the continent. Further declines are probably inevitable now, as seasonal wind generation starts to rise. But the damage to Russia’s credibility is probably permanent now. Data over the past month has clearly shown that Gazprom controlled storage capacity in Europe is not only unusually low, but is lower than in other comparable storage units. It’s reasonable to speculate therefore that Europe may retaliate by not only denying Russia the permission to build more natural gas pipelines, but by aggressively ramping up the deployment of storage. The Gregor Letter faulted Europe for failing to pair storage sufficiently with its fast buildout of new wind and solar. The Autumn 2021 natural gas crunch looks like the perfect catalyst to course correct.
President Biden has found himself in the unfortunate position of asking OPEC to increase supply on the eve of COP 26. While it’s true that OPEC has at least 6-7 mbpd of spare capacity, it is also true that neither US political party wants to touch the third rail of US energy policy: the existing fleet of ICE vehicles. Why? Because a broad coalition of voters who identify as Democrats, who are certain they want to do something about climate change, and who are certain that it’s only Republicans who are in the way of forward progress on climate policy are, themselves, unwilling to be taxed or disincentivized for ownership of CO2 emitting vehicles. The Gregor Letter has pointed out this rather inconvenient truth multiple times. Governors and mayors in deep blue states like Massachusetts, Rhode Island, New York, Oregon, Washington, and yes, the big one, California, would not and will not dare to introduce road pricing, emissions pricing, or any levy or charge that would place even a small token fee on their voters. Because their voters are drivers. Be honest now: are you willing to pay a London-like day charge for driving into Boston from any direction, say, at $7-$10 per trip? Are you willing to increase gasoline taxes on yourself? How would you react to a device placed in your ICE car to charge you an annual carbon fee based on the number of miles driven? Among the oil games, this is perhaps the most cruel of all.