Over the 18 months since June 2014, the price of Brent Crude oil fell from $115 per barrel to a trough of $32 in January 2016. After last year’s oil-price rebound, many analysts think that oil can’t get much higher than $60‒$65 a barrel in the next three years. Our research suggests that these projections underestimate the costs of producing oil in order to meet global demand growth that increasingly relies on US shale. We think oil prices could touch $80 by the end of the decade.
Strong demand: Over the past four years or so, global demand for crude oil has increased by roughly 1%‒2% per year, peaking at 2.4% growth in 2015. Projecting through 2020, we see a steady 1% annual rise in demand.
Fading non-US, non-opec supply:
1.members of OPEC have until now met much of the annual increase in demand. <- Iran, Saudi Arabia and others have little scope to grow capacity.
2.Production of non-OPEC, non-US oil-producing countries has declined, while US production has started to recover recently from a decline over the past two years.
<- With oil below $50 a barrel until recently, investments in new oil reserves just weren’t profitable + Since new exploration and production (E&P) takes a few years to bring online, that lack of investment due to low oil prices in 2014‒2016 could suppress oil supply levels for years.
3. US oil production will be essential to meet steadily growing global demand for oil
-> in the coming years, oil prices will be increasingly determined by the costs of extracting that oil from various US shale deposits.
US shale activity declined in synch with the falling price of oil from the summer of 2014 through early 2016.
-> As oil prices fell, E&P companies drilled fewer wells, but focused on more efficient shale wells. The US shale drilling locations are grouped into tiers based on their level of productivity and economics. The tier 1 wells, which produce oil more economically, made up 38% of the oil wells in the first quarter of 2014 and have grown to 49% of the mix today.
–>> Unfortunately, there are only so many tier 1 shale sites, and based on current estimates, all 26,000‒27,000 of these sites will be depleted halfway through 2019. +Furthermore, as US activity ramps up, the cost of drilling and completing a well will rise.
–>>> If this plays out, E&P firms would then need to shift their attention to tier 2 locations, which are less efficient. Our research indicates that the cost of drilling profitably at these locations would require WTI crude—the key benchmark for US oil prices—to reach $78 a barrel by late 2019, when accounting for inflation of drilling costs.
*At current costs, the breakeven price is about $45 a barrel. And since the world will be looking increasingly to the US to meet ongoing demand by 2019 and beyond, we think the economics of drilling at tier 2 sites will start to set the oil price in 2019.
-> As the long-term recovery unfolds, energy stocks—especially oil producers and oil-services groups—could continue to outperform.
Risks to the assumptions:
An unexpected recession could undermine demand.
OPEC could surprise with much higher production.
And new technology could theoretically uncover more tier 1 shale locations.
Oil is indeed the real McCoy, a true paradigm shift. But it, too, faces a short-term glut caused by U.S. fracking.
– U.S. fracking oil is a small resource, under one and one-half years of global consumption. It will soon run off and show the underlying implacable rising costs of finding ever-diminishing pools of new oil.
– Existing oil wells deplete faster than they used to, because enhanced technologies squeeze more into the early years. Over 5 million barrels a day out of a global total of 95 a year now needs to be replaced every year. Half a new Saudi Arabia!
– Today’s draconian cutbacks in exploration almost guarantee another sharp price spike in the next two to four years.
– But beyond a five-year recovery for oil prices and oil stocks, there lurks a third paradigm shift: the terra incognita of electric, self-driving vehicles; cheap electric storage; climate change; and carbon taxes. Taken together, this shift to alternative fuels is likely to cause oil’s final paradigm shift!
History and investment
The only thing that really matters in asset allocation is sidestepping some of the pain when the rare, great bubbles break. At other times, traditional diversification will usually be good enough.
The Japanese equity bubble: the best example of an extreme outlier that nevertheless turned out to be an epic bubble rather than a paradigm shift.
* Every major bull event is called a paradigm shift, but they almost never exist. Almost never. But not never, ever.
Oil, by 1979, had once spiked to over $100 a barrel in today’s currency. Against the previous 100-year trend of $16 that was over a 1 in 1 billion long shot.
The author used to believe:
1.This 1 in 1 billion 1979 event was caused by the newly effective cartel, OPEC. The response of oil prices could not have been caused by any mixture of pre-existing factors. It was therefore a paradigm shift. But cartels can end. This produces a special case of paradigm shift: likely to last as long as the new factor, in this case OPEC, stays effective.
2. After 1999, the costs of finding new oil started to rise very rapidly. By today, in my opinion, the price needed to support the development of new oil reserves has risen to at least $65 a barrel. This rise from $16 (in today’s currency) constitutes a second paradigm shift in oil. Less is found each year in smaller fields, and is more difficult and costly to extract.
3. If we were running out of low-cost oil, I asked myself in 2011, why should we not run out of other finite resources? Also, China uses a much larger fraction of total global minerals than it does of oil. China’s growth, together with increases in world population was causing us to be facing “peak everything.”
*”But alas, I was fooled – along with all of the CEOs of the miners – by China. The four-sigma event in mineral prices did not occur because those resources were running out. Not yet.”
Food is in a comparable situation to metals, though, in that it faces a short-term glut. But for very different reasons: Almost four years of terrible growing weather and ensuing shortages and buying panics had pushed grain prices so high that an unprecedented quantity of extra land was brought into use
■We believe the prices of many commodities will rise in the decades to come due to growing demand and the finite supply of cheap resources.
■ Public equities are a great way to invest in commodities and allow investors to: 1) Gain commodity exposure in a cheap, liquid manner; 2)Harvest the equity risk premium; 3) Avoid negative yields associated with rolling some futures contracts
■ Resource equities provide diversification relative to the broad equity market, and the diversification benefits increase over longer time horizons.
■ Resource equities have not only protected against inflation historically, but have actually significantly increased purchasing power in most inflationary periods.
■ While resource equities are volatile and exhibit significant drawdowns in the short term, over longer periods of time, resource equities have actually been remarkably safe investments.
■ By some valuation metrics, resource equities have looked extremely cheap throughout 2015 and the first half of 2016, and that may bode well for future returns.
■ Given the difficulty in predicting commodity prices, the low valuation levels of the past year and a half may be unjustified.
■ Despite all of this, investors generally don’t have much exposure to resource equities. Those investing with a value bias may be particularly underexposed to resource equities, as value managers tend to be especially averse to the risks posed by commodity investing.