Understanding Sheer Momentum in the Energy IndustryKeeping things here on topic, here's another effort to sum up my take on some issues, efforts, and news items we have posted about on this board.
I want to point out the magnitude and sheer momentum of all the things that are in motion in the energy industry. This moving mass of suppliers and consumer is not easy to change with a few headlines. There are trillions of dollars and over a century of development in supply infrastructure of our fossil fuel energy system, from exploration to the car you drive. The kinds of transitions we have made in the past from biomass to coal, then to oil have taken more than decades to acheive, and also at a much smaller scale.
With each headline or news item, we must step back and measure what things truly have meaningful impacts relative to the course of oil as an energy source, which in turn guides our investment decisions. In the end, there are 3 choices of either buy, sell, or hold.
I have used the analogy before. I see the energy industry as a whole and many things connected to it are like a massive ship underway at sea. To expect something to abruptly change it's course would require unimaginable forces. However, by turning the wheel, shifts in course can be made gradually, but the lag we have before seeing it turn is far longer than you would expect.
We can apply this analogy of momentum to some concerns recently posted:
-Russian Sanctions
As we crank the wheel turning up energy sanctions, it will take a while for them to start to bite. Purchase contracts made prior to the sanction announcements must be fulfilled, and loadings for these continue for a while yet. Roughly, out of the 10mm bbls of oil and liquids produced in Russia daily, 2 are consumed there, 4 are exported by ship, and 4 go by pipelines west to Europe and southeast to China. The oil supply chain for Europe from Russia is mostly fed by pipeline, and is about 30% of their oil supply, some countries more some less.
Some refineries within the middle of landlocked Europe do not have any other means crude supply than what arrives from a Russian pipeline. Is there enough crude on the global market to displace Russian crude for Europe? Yes. However are there enough terminals to unload, are there enough pipelines for distribution? There are big logistical changes that must be worked out before they can cut off Russian oil supply and secure the replacement crude. This is happening at a time when diesel is at such critically low levels in the EU. It will take a while.
For those buying Russian crude exports from the Black Sea terminals, they also face challenges and risks going through a war zone to get it. Carriers can't get insurance, and undergo further transit distances shipping to Asia. Much further distances are involved for shipments from the Baltic ports, going around Spain, the Med, Suez, to Asia.
Russian storage on site is filling up fast, and some places have only about 5 days of available storage left from 50. Some Russian refineries are closing due to product storage reaching capacity. Russia must ship both crude and products, otherwise face damaging production shut ins that reverberate throughout their production infrastructure. They are filling up everything that floats or rolls.
On the natural gas front, there is a strange situation. It seems to be in nobody's interest to halt supplies to Europe. Even pipelines through Ukraine are not being shut off by the Ukranians. The backlash and risk of losing support from Europe would perhaps be too risky for the Ukrainians, Europe needs the gas, and Russia needs the money. With all the destruction, everyone there killing eachother are very careful not to blow up a pipeline...yet.
Remember, gas is not like oil, and the infrastructure to make LNG, transport, and store it does not exist to the extent it does for oil globally. It will take many years to replace and curtail Russian gas supplies, as the world scrambles to build more LNG plants, berths, ships, pipelines, and distribution networks.
As China and India benefit from cheaper Russian sanctioned oil, the cargoes of oil they would have normally bought from the ME will now be bought by the west. There will be a shift in shipping destinations as a result, leading to more volumes of oil in transit, at a greater cost. This displacement will take months to work out in the system, as the momentum of the oil trade has such a long lead time.
At some point further down the road, as Russian energy is reduced or removed from western consumption, and most heads to Asia, there will be some balance reached. Russia will try to move as much oil as possible for any price. We will see a peak in Russian oil production, and without western expertise, it's slow decline will become a faster decline which should hurt. As a result of the west taking the high road among nations as it has done with climate, it will be costly for us, yet be a great benefit to China and India to consume cheap oil as they continue with the status quo.
Reducing Russian oil and gas exports to the west will take time, but overall they will end up exporting less, at a lower price.
-New Federal Oil Leases bringing on new Production
No immediate impact. The long term nature of the production cycle makes one ponder how one would think that this announcent of a small increase in permits could lower immediate pump or WTI prices. It does serve to anger Biden's base environmental support by breaking a campaign promise. If he would only break the Keystone cancellation, that would be help us.
Companies are in a constant state of developing wells in an orderly fashion, and must have an inventory of land they can produce from in the future years, or cease to exist as happens in a boom and bust cycle. They must look forward a few years so they don't use up their remaining inventory of leases too quick, and run out of runway. The current administration's energy policies have made their future ability to get leases unknown, causing them to be very selective in their use of permits. Also, when it appeared that Biden would come to power, it was like announcing 'Last Call' at the bar, so many loaded their table with drinks and bought as many permits as possible before the bar closed for good.
It takes many years on average to get oil from a lease. There is surface permits, environmental studies, stakeholder issues, exploration, then if it looks favourable at all, more exploration, then drilling, then fracking, then pipelines, and production along with restricted flaring rules where they must pipe the gas for processing. This normally takes a long time, and now even longer.
Remember the massive inventory of DUCs we had in 2020? Recent increased oil production we have seen in the US has largely been the result of the completion of these wells as they came online. The level has now normalized, and the excess DUC inventory has been absorbed. A well becomes drilled, a DUC, then fracked. Shortages and delays happen with materials, labour, and equipment, at every stage. With shale, you can bet that the prime acerage has been developed, and we are moving down the line to secondary favourable formations, requiring more and more drilling and fracking to get the same amount of oil, but with the similar rapid well depletion rates. It will not return as we expect as it did before.
Public E&P companies have blown their brains out in the shale boom pushing to increase production with every available dollar. The capital lost in the collapse was staggering, and caused lending to evaporate. Many went under. Equipment was scrapped and liquidated. Employees left. The industry now experiences shortfalls in everything, and it is far more expensive. Frac sand, chemicals, labour, rigs, steel, pipe, frac spreads, water, everything. Risk has increased, as the time from comencement to first bbl has become far longer.
In the case offshore leases, the timeframes are even longer, about a decade.
-China Lockdowns, Economic Slowdown
These are potential bigger wildcards, and there is less confidence in predicting the outcomes.
It is interesing that China started restricting purchases and imports of crude long before the current lockdowns came about. Crude quotas for the private teapot refiners have been curtailed by 50%. Product export restrictions have been put in place as well. It seems to all be shifting to favour China's state refineries. There have been shortages of fuel in some areas, and the lockdowns are starting to create some civil unrest. China has to be careful how to manage that. The main vaccine they used in their fight 'Sinovac', has been quite ineffective in preventing the spread compared to western MRNA vaccines. Thailand pushed it, but most of the population here wouldn't take it, myself included. As the world moves to declare Covid endemic and open up, China is not admitting defeat in their zero Covid policy. The question is when will they get back to normal, and get to work. With 40mm people on lockdown, oil consumption is now estimated to be down about .5mm bbls/day. This will create more product supply chain issues, and shipping backlogs. When they return, they will need more.
Recession in Europe is happening now, but the US is still hanging on with growth. Real wage growth has dropped, yet the employment figures are still good in the US. Interest rate increases are priced in, and peak inflation is poised for 2023. Supply chain issues and higher costs for energy and materials that have a high energy component are big factors that are driving it. Corporate earnings continue to look good at the moment, however as prices go up and if the economy falters, that may change. Technically, shorting the Nasdaq and S&P seem like the trade to consider as headwinds start to become more intense.
One might question whether to have anything invested in anything at all, and stay in cash as it buys 8% less each year with inflation. Knowing that my money will be worth 8% less in a year due to depreciation, is not a good investment plan in my opinion.
Clearly, both Covid and past recessions have reduced the price of oil in the past. Presently, production hasn't even had a chance to recover from the double blow of Covid and negative pricing. We are not increasing global supply. We are drawing down crude and product inventories including SPR as demand continues to grows, even while oil is at $100 WTI. A mild economic slowdown would likely bring supply and demand closer in balance, but with all the increased costs now associated with producing oil, the marginal costs are a lot higher for many.
One must keep in mind the longer term affect of global capital underinvestment in E&P and the impending production decline rates which will lead to a drop in supply. In the meantime, demand growth in non OECD countries will occur as millions move from the poor to middle classes, soaking up a lot of that extra oil freed up by increased efficiencies, lower economic activity, and moves to renewables.
As a hedge to energy inflation, it makes sense to me to hold a higher proportion in energy stocks to counteract the devaluation of your currency will in the future. If energy is a main driver of the inflation we see, it should make sense to own it.