This will be my last post on oil as when I do post in the future it will be on our wonderful Company Gamehsot.
I'd like to clarify my view on oil and oil stocks briefly, as it would take way too long to go into great detail.
This is not my main point but I’ll start here. The demise of oil is way overblown. Oil will not disappear any time soon. The world will increase by 2 billion people over the next 25 years and the majority of the increase in population will be from the undeveloped world where oil is basically not being used. So when the undeveloped world starts to sue oil it will ramp up fast. Remember 40% of oil demand is from population size and not transportation.
In non-COVID times the world uses about 102M barrels of oil per day. Let’s round this down to 100M. We know that oil used for transportation is 60% of all demand and oil used for living standards is 40% of oil demand. So sticking with our round numbers, this means 60M barrels of oil per day is for transportation and 40M barrels of oil per day is for living standards.
Eventually oil peaks out and demand will start to erode. True but this does not mean demand falls off a cliff. It is also not going to be declining at the same rate throughout the world. It will decline in the developed world and will actually increase in usage in the poorer countries.
I know that all scenarios are debatable. Nobody knows for sure what will actually happen. However, let us assume that demand for oil for living standards, which is based on population size, increases by 5% per year (remember there will be 2 billion people extra and most from very poor countries where oil is a necessity for life and won’t think twice about using it when it becomes possible to do so). Then to offset this increase in global usage, oil used for transportation sources would have to decline by more than 3.3% per year. If oil used for transportation sources declines at a pace of less than 3.3% then you get an increase in global oil usage. I only use this example to point out that there are two sides to the equation and both sides must be considered. Most of the additional 2 billion people added to this earth will be in poor countries that will start to use oil and it will ramp up quite rapidly. That must be kept in mind.
Also, a lot of countries that we would consider to be poor have cars and they are in the category that says 60% of all oil usage is for transportation. They however keep their cars much longer than we do. Some of these cars are well over 20 years old. They can’t afford to get new cars and they certainly will laugh at you if you suggest they should get an EV. When they get a bit richer they will buy more combustible engine cars and oil used for transportation from these countries will increase and therefore the overall pace of decline globally may not be as fast as is expected.
The transition to green will take longer than what most people expect as transitions in anything always do.
And now on to my main point:
My main point is that oil supply going forward will be limited by design. People in the developed world have changed since about 2008. They are more aware of the environment and we are audibly hearing a collective social conscience. I see this everywhere and everyday. Most of it is well intentioned. Some of it is misguided.
People of my age and younger, generally speaking. care deeply about the environment. Each in his/her own way and each to a different extent. Each believes the actions they take are to protect the environment and the people they care about. I believe the people of my generation and the younger generation behave this way as a result of being more familiar with technology and in particular social media.
News travels fast today. Faster than at any point in history. Technology and social media are the reason for this. This is good and this is bad. Good because real issues and news needs to be known by the populace. Bad because facts can be distorted and spread rapidly through social media based on the senders agenda and believed by the populace.
Indeed the world needs to get off oil. I totally agree with this. But at this point in time we can't. Our economy would be stopped dead in its tracks if we stopped using oil. Everything would stop. One day we can be off oil but that day is not in my lifetime. We will still be using oil decades and decades from now. Not the same amount as today. Much, much less but we will still be using it. That is the reality that people of my age and younger don't want to hear and don't believe.
They don't believe this because they are focusing too hard on what is obvious and not hard enough - or even at all - on the logistics of change. I believe social media is having an effect of shortening people’s attention span. Kind of like a collective attention deficit disorder.
People are focusing on the obvious, which is that the world cannot go on using fossil fuels. If we do, the world will keep warming, yes science is correct and this is not a lie, and we will suffer major catastrophe after major catastrophe. We can't keep beating up the world and expect it to not fight back. We all know that medication has side effects. Well, if we do bad things to our planet it has side effects too. and it is called global warming. Change is needed. This is the obvious that too many people are only focusing on.
What is not obvious is how do we as a society get off oil while not having our entire economy come to a full stop? And it would come to a full stop. Think what would happen if oil was gone tomorrow. The machinery that farmers use is made by using oil. They are powered from oil. How do we get food to grocery stores? What about transportation? Heating, making medication, everything around you has oil in its equation. Hospitals would not function. Jobs would be lost everywhere. We would go into probably the biggest depression in history and there would be so much death and suffering.
Clearly oil is needed until we can have a large amount of reliable green technologies that can take care of our needs as a society. We've been living off oil for almost 200 years and are dependent on it to this day and we expect to get off of it in 10 years? Unrealistic! We should have taken steps in the 1970's but we didn't. We need to transition. And in transition we need oil. Tesla cars appear to be wonderful but it still takes 50 barrels of oil to make one Tesla car. At this point in history, we can't get away from the fact that we still greatly need oil. It won't always be like this but for now it is.
All of the above is to say that the younger generation believes they are acting in the best interest of the environment by wanting to have nothing to do with oil. They are a loud voice and are listened to due to the use of social media. They vote. Politician listens.
Politicians are not the only ones listening. Oil CEO's and oil investors are also listening. We are saying "don't oversupply" to the CEO's. The oil CEO's are listening to the investors. They see the future. They are constantly being told that oil has no future by society and so they are very reluctant to engage in long-term projects. They just won't go there. Why should they invest billions of dollars and take 5 - 10 years for the project to come online and produce when they are told that oil is unwanted?
Here are some by factors why future oil supply will be permanently limited:
- No desire from the supermajors to build out long-term billion dollar projects
- U.S. shale petering out and all cheapest wells dry. Only more expensive ones left and petering out
- Cornerstone analytics saying OPEC will be out of spare capacity by Q4 2022
- 8 OPEC member countries cannot meet their quotas
- Saudi Arabia real breakeven price not $5 but closer to $75 when you factor in military and social spending and so they need $80 oil
- $2.2 trillion lack of investment in oil industry cumulatively since 2014
- Oil CEO compensation no longer tied to production levels but tied to return of capital to shareholders and therefor no incentive to produce more but incentive to increase free cash flow
- Oil CEO discipline is the new reality as they all no oil demand will start to fall and keep on falling and so they don't want to increase production and kill the price of oil
- Oil CEO's and oil nations all know that they will be selling less oil over time and so to remain profitable they need a high oil price and there cannot oversupply as it is suicide.
The end result The above are just some factors to show that we will see sustainably high oil prices. This is the new reality. Recessions are short term blips. Oil will always fall in a recession but will always rise once the recession is over. Recessions are like colds. We all get colds but they are not the end of the world. All healthy people get a cold from time to time. They come and go. Recessions are not the end of the world. They come and they also go. Investors need to use recessions to their advantage and not be afraid of them. Stock prices fall in anticipation of a recession. The intelligent long-term investor buys and holds. We are not frightened children and should not act like them.
So it is my view that the lack of supply, irrespective of the level of demand, will cause oil prices to be sustainably high over time. As demand decreases, so will supply to keep the price of oil at a level that companies and nations are comfortable with. It is a supply issue and not a demand issue going forward. A new reality.
Initially, oil companies will be generating increased levels of free cash flow as demand comes back over the next few years to somewhere likely between 2025 - 2035.
These free cash flows will be used to pay down debt. The Canadian energy sector will be debt-free as a whole by mid-2023.
At this point we will not see any material increase in production as a result of the new CEO discipline due to the above mentioned factors but will see increased stock buybacks and dividend payments. I believe this will attract more interest from portfolio managers and the sector will rise.
After a few years of heavy stock buybacks, the free cash flow on a per share basis will be substantially higher causing further upward movement in stock prices and create the fear of missing out in retail investors and in portfolio managers that are underperforming their benchmarks. If a portfolio manager underperforms for too long he gets fired because mutual fund unit holders sell mutual funds that don't perform and so the manger gets axed. This forces other fund managers to start to buy oil stocks and pushes prices higher.
If prices are still very cheap then mass consolidation starts to occur in the industry as the opportunities are too good to pass up and it is cheaper sometimes to buy oil via acquisition than to drill for oil. This forces prices closer to their intrinsic values.
As oil reaches peak demand and starts to fall, oil companies reduce their production even further. The free cash flows start to decline. The oil companies keep buying back stock and therefore on a per share basis the free cash flow increases. A further wave of consolidation will ensue resulting in very few companies remaining relative to today’s levels but much larger in size with diversified operations.
However there is also the possibility that the price of oil could actually increase after we reach peak demand. This is a possibility and would result if supply decreases faster than demand evaporates. This must strongly be acknowledged as having not an insignificant probability of occurring. Less demand means less production and the commodity takes on scarcity, which always translates into higher prices.
Lastly, let us not forget that oil in not infinite. However the Canadian oil sands have very long lives indeed!
Either way, oil will be needed for decades and I believe prices will be elevated.