The Future State of Oil and Natural Gas, by Harish Jai Ganesh and Rutvij Thakkar
- The Dogs Of Dalal Street Podcast
- Sep 27, 2020
- 9 min read
Oil had always been the lifeblood of modern industrialized civilizations. Oil is used everywhere; in plastics, in our roads, in our vehicles, and it drives nearly all types of transportation. Oil prices typically have an inverse relationship with the stock market, which holds true right now, but not for a good reason. Disagreements within OPEC countries to regulate the price of oil have failed, leading to falling oil prices and rising reallocation of capital into assets in other industries as institutions rapidly lost interest in adding the (now) very risky asset to their portfolio. This, paired with the reduction in consumption of oil for transportation have led to oil companies drastically losing their exchange value. Buying one share of the U.S. Oil Fund (USO) ETF would give your portfolio exposure to roughly one barrel of oil, which will be the visualization for the day:
USO’s price is now at ⅓ of it’s Pre-COVID valuation
Natural gas is down 50% from its 52-wk peak
While industries like tech and pharmaceuticals have recovered, oil and gas has yet to recover due to pandemic fears and international tensions, which have led to a mass exodus of equity funding for oil and gas companies and the commodities of oil and gas themselves. Many fear that COVID has just been a symptom, and not the cause for the contraction of the oil industry, that this collapse was inevitable and already in the cards. Why, because any stock that attached its name to renewable or electric has seen massive growth, that’s why! Not the most likely case though, because while oil consumption may reduce in the United States and Europe, as the world’s population grows it’ll be nearly impossible to replace all oil with alternative energy simply because oil-based products are cheaper to produce and manufacture and widely available. As the pharmaceutical and biomedical industry expands in these countries, oils will be necessary for them as well, and as infrastructure expands and more roads are built more asphalt and plastics for building materials will be needed, more oil will have to be produced to support infrastructure growth and demand. Innovation in oil and carbon-based fuels has never stopped, and it never will. The prices of oil are almost entirely determined by the economic growth of countries, which today is very hindered hence the low prices of oil. According to the US Energy Information Administration, “Economic growth is one of the biggest factors affecting petroleum product—and therefore crude oil—demand. Growing economies increase demand for energy in general and especially for transporting goods and materials from producers to consumers”. So the entire point here is, because oil prices are so much in tandem with the economic growth of developing nations, oil will be severely damaged as an asset until developing countries get back on their feet and grow industrial production as normally planned. We can almost be certain that oil growth will then continue on its planned trajectory as the living standards for developing nations will continue to go up. How can we be certain that oil will be the first course of action for giants like India and China? Well here’s my personal list of reasons why:
Population growth for both countries has yet to peak, so the same applies to energy consumption
Renewables such as hydropower, wind power, and solar power require far more land use and certain environmental constants to be harnessed
Renewables have needed heavy subsidization, which poorer countries are not likely to provide.
This results in renewable energy being more expensive for the middle class, as a matter of fact in US States with quotas for renewable sources, the utility prices are up to 50% higher than in states with no quotas (https://www.brookings.edu/blog/planetpolicy/2014/05/20/why-the-best-path-to-a-low-carbon-future-is-not-wind-or-solar-power/) “To place these additional costs in context, the average cost of electricity to U.S. consumers in 2012 was 9.84 cents per KWH, including the cost of transmission and distribution of electricity. This means a new wind plant could at least cost 50% more per KWH to produce electricity, and a new solar plant at least 200% more per KWH, than using coal and gas technologies.”.
This along with the fact that 30% of the US’s electricity comes from natural gas shows that we have yet a long way to go before completely kicking out carbon based fuels.
What does electricity have to do with oil? Well about 70% of all of the oil used in the US is used for transportation (http://www.americanenergyindependence.com/fuels.aspx#:~:text=U.S.%20Transportation%20fuel%20consumption%20accounts,amount%20is%20for%20personal%20vehicles.), and right now the paradigm for transportation is oil and gas run vehicles.
China has become a net importer of oil for a while now, as its GDP grows exponentially year on year and their population growth sees no sign of slowing down in the near future, and as the need for individual transportation increases with more urbanization in China, we can expect a high demand for vehicles from both China and India as more household become upper middle class and both economies open their economy’s doors to higher standards of living. (https://www.forbes.com/sites/judeclemente/2015/03/18/chinas-car-gasoline-and-oil-markets-to-2020/#5325436537ea)
China GDP per capita growth
Oil price inelasticity (economic term for no damage to demand despite higher/lower prices) will be a big contributor to the generally conservative industry’s comeback.
A huge factor to oil prices that is arguably playing a much bigger role in oil prices are the decisions of OPEC, an oil cartel of 13 countries that control 40% of the world’s oil supply. The mission of OPEC is; in its most simple form, to fix the prices of oil and control the pricing power for this commodity. The OPEC would control prices at will especially in the 1970’s and the 1980’s so that they could maximize their profits:
West Texas Intermediate Crude around the time OPEC was formed (MacroTrends)
And again as the US becomes energy independent as a net exporter of oil since 1957 (see chart again), OPEC is hiking up their production so that the US has to reduce the production of their (at one point worthless) oil. OPEC member countries often produce more than their agreed quotas because nobody can really stop them, and this results in oil pricing wars.
Credit: YCharts
The increased production of oil from Russia and Saudi Arabia has forced the US to halt its operations so as to not lose money on each barrel of oil sold. This is forcing the US out of becoming a competitive seller of oil, and that’s OPEC’s entire strategy: to make sure the US, Canada, and China stay dependent on them for oil, because America’s energy independence would force the OPEC members out of business:
OPEC oil price gouging typically stabilizes as the different countries drive up price by decreasing production when prices are set too low, and countries lower the price by increasing production when prices are set too high. New developments in the middle east such as the U.S. brokered peace treaty between Israel and the U.A.E may also help ease OPEC tensions. Historically, OPEC relations have always stabilized shortly after quarrels due to the global reliance on oil, so it’s reasonable to assume that the same will happen now.
WTI crude has already started a recovery as you can see below, but oil companies still remain significantly impacted from shutdowns.
As you can see, the crude oil price initially fell to around ⅓ of its pre-COVID price then recovered to ⅔ of that initial price after demand slowly began to increase again.
Oil equities have been most adversely impacted from the shutdowns, not the commodity itself.
Global oil demand has reduced by around 10% this year:
Current daily demand for oil per day this year is around 91.7 million barrels per day, down 8% from last year, mainly due to COVID-related lockdowns
Average revenue for oil companies has fallen around 30%. While this means that the average net income has become negative for this sector, that is due to a normal net income margin of around 7-9%. Given that revenue has fallen 30%, with companies having limited time to reduce operating costs so it makes sense for these companies to now have negative net incomes, and this should not be held against companies in this industry due to high fixed costs which are necessary for machinery and refineries that must be kept operational and in good condition even in times of low oil demand. It’s a similar situation for manufacturers or hotels, they have so many operating expenses and such slim gross profit margins that they have to take on debt in order to have all the equipment maintained for future production. As of now, oil giant Exxon’s profit margin is at a measly 1.5%.
But oil is becoming a scarce resource with harder to replace alternatives, so much so that companies are seeking out alternative ways of accessing oil such as tar sands.
“Fundamental economics support sticking to oil & gas until the bitter end as supplies decline. The key point is that because oil is an essential commodity with very limited substitutes, the market price of oil will continue rising until it's high enough to to justify bringing more expensive production on line. The less oil is left, the more money there will be in sucking out every drop. Scarcity increases profits and encourages companies to expand, not contract” (https://www.forbes.com/sites/quora/2017/08/17/how-big-oil-companies-are-planning-their-futures/#189642784650).
Electric cars would replace a lot of the need for oil, but as we saw in China for 2020, the net demand for electric cars was even lower than for regular automobiles (https://www.iea.org/reports/global-energy-review-2020/oil#abstract) due to them being far more expensive to produce, and not necessarily even “green” in the first place due to the mining of lithium and cobalt to produce batteries for these vehicles. If governments actually trace the amount of carbon it takes to produce a “zero emission vehicle” they’ll find that electric cars with unclean energy sources and bad mining practices are nothing but gimmicky toys not worth giving huge subsidies to: (https://www.scientificamerican.com/article/electric-cars-are-not-necessarily-clean/).
A vaccine release by the end of 2020 makes it in the realm of possible for a full reopening by the summer of 2021. Even though we’ll reopen soon, there is the question of whether oil usage will go up back to normal level after the reopening.
For this, we must look at where oil is most used. 61% of all oil is used in forms of transportation as gasoline, diesel, jet fuel and the International Energy Agency reports that “Global road transport activity was almost 50% below the 2019 average by the end of March 2020 and commercial flight activity almost 75% below 2019 by mid-April 2020.” This corresponds with the previously found loss of revenue for companies in the oil sector.
That brings us back to the question of whether oil demand actually rises back to pre coronavirus level post pandemic. For a good look at what will likely occur in the U.S. after the vaccine release, we can look at China’s recovery. As China has contained the virus to one small city and reopened, it can be treated as analogous to a post-lockdown U.S. The following information is sourced from an Oxford Energy study. The following graph shows the oil demand in China:
The oil demand for transportation fell to less than -2.5 million barrels per day at the beginning of 2020. That sharp decline in demand was quickly replaced with a sharp incline and oil demand reaching 4 year highs. While the demand for jet fuel remained in the negative, demand for diesel, gasoline, and fuel oil alone set new records. This also led to China having record imports of oil:
Looking at Figure 2 then figure 4, it’s clear that the rise in oil imports is not hurting the bottom line of oil companies based in China, but these imports are rather a supplement to a large demand for oil.
These imports were mainly from the U.S:
Post coronavirus oil demand was so high that the established infrastructure for oil refineries in China was overloaded and mass imports were necessary. However, these imports were not taking away any profits from local oil companies either.
Here is the local oil refinery output from China:
Oil demand was so high that not only were refinery runs at 4 year highs, but massive imports were necessary as well to keep up with the demand. Similar rises in oil production in the U.S. after the covid lockdown will allow for massive profits for oil companies along with the opportunity for them to upgrade their refineries and increase their total revenue.
Oil and gas has always been a very successful industry and the pandemic is only a temporary slowdown. A vaccine in the near future will drive up oil demand pushing these oil companies back to their former market values, or to much higher market values than what they have currently due to the expected inflation in the future. Oil companies with the established infrastructure to manage high demand are on sale right now as their stock valuations are at a fraction of their former prices, and their prices are not even close to in-line with the commodity itself. If you invest in the most competent oil companies, you should expect them to eat market share of smaller, worse ones and improve their margins even more. Oil companies with a diversified consumer base, vertical integration, and low debt should be primary investment targets. An investment in these companies will likely yield a good return both in the near future, and in the long run, as many of these oil giants provide stellar dividends as well.
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