Are $100 Oil Prices Realistic? Maybe Not By End-2023, But Almost Certainly By 2025.
Discover more from Value Investing Substack
Are $100 Oil Prices Realistic? Maybe Not By End-2023, But Almost Certainly By 2025.
Fantastic Oil Price Insights Summarized from Goehring & Rozencwajg, Arjun Murti of Super-Spiked, Open Insights & Value Investing Substack
This article is a summary of oil price insights delivered by various esteemed sellside analysts — including Goehring and Rozencwajg’s Q2 letter, Arjun Murti of Super-Spiked and Open Insights.
I’ve also included an excerpt taken from my earlier Occidental Petroleum report, which included a global oil demand/supply primer — if you want to read the full OXY 0.00%↑ report, click the link below:
Goehring & Rozencwajg’s Q2 Letter
Full letter download link (requires free email registration)
The Coming Surge: Oil’s Bullish Horizon Amid Investor Apathy (Link)
“We Are Amazed At the Level of Investor Apathy and Disinterest.”
Summary
Many market commentators attributed underperforming oil prices in 1H23 almost entirely to failed initial expectations of global oil demand roaring back from a China’s reopening scenario that didn’t materialize.
However, the liquidation of 26 mm barrels in Q2 from the US Strategic Petroleum Reserve (SPR) also contributed materially to depressed oil prices — remember, oil prices move at the marginal barrel, not total stock.
In July, the DOE unexpectedly announced a cancellation of further SPR liquidation in favor of “refilling” the SPR. It had initially been scheduled to sell 155 mm barrels over the next 4 years — 42.5 mm barrels in 2024 and 2025 each, and 35 mm barrels in 2026 and 2027 each.
It is no coincidence then that oil prices started rallying in end-June.
As a result, SPR sales are likely to be zero over the next four years, instead of the aforementioned 155 mm barrels. This is a material factor to future global supply, as the US SPR liquidated 220 mm barrels in 2022 alone — this was done amidst extremely tight global supply conditions caused by the Ukraine war, which is unlikely to persist going forward.
G&R estimates that oil is fairly valued at $75, based only on commercial inventories. Once the now-depleted SPR is taken into consideration, they think oil should be trading at $120/bbl. Brent oil prices are still at $92 today.
US SPR sales in Q2 were partly influenced by the Bipartisan Budget Act of 2018, which mandated the US to sell oil from the SPR to fund spending bills. However, such sales are automatically “phased out” if SPR reserves fall to 350 mm barrels — which they already have.
With the US no longer selling from the SPR, commercial inventories will have to make up the difference in supply — and are expected to fall dramatically.
US commercial inventories are currently in-line with 5Y averages. However, after including SPR reserves, total inventories are at a record deficit at 300 mm barrels below the 5Y average.
Global inventories are just as tight. OECD commercial inventories are currently 95 mm barrels below average. Including government stockpiles, inventories are 400 mm barrels below average — another record.
The longer-term supply outlook remains exceedingly tight. According to the EIA, the Permian was growing output by 700k b/d in February; this is forecasted to fall to 360k b/d by August. By end-2023, G&R’s models suggest that Permian production growth will fall to 100k b/d; and is likely to turn negative in 2024.
This is pertinent because the only sizeable source of non-OPEC+ growth over the past 15 years has been the Permian basin. Permian producers dropped 14 rigs in Q2; and shale production outside the Permian hasn’t grown in nearly 3 years. This is despite an environment of oil prices rallying from $20 to $75 per barrel.
The IEA forecasts Non-OPEC+ production growth ex-US at 400k b/d this year. However, G&R thinks that this might be too optimistic, as the IEA has systematically revised this figure lower by 300k b/d in the past.
As Non-OPEC+ production falters, OPEC+ will gain market share and pricing power — as evidenced by Saudi’s extended production cuts in August. Whether this was for demand or supply reasons, what is undeniable is that the Saudis are no longer afraid of losing market share to US shale (i.e. pricing power).
The IEA forecasts average global demand at 103.2 mm b/d in 2H23. Global supply will only reach 101.5 mm b/d, leaving the market woefully undersupplied by a massive 1.7 mm b/d — remember, oil prices move at the marginal barrel.
G&R thinks that even this IEA forecast understates the global supply imbalance, as the balancing item was 1.3 mm b/d in 1Q23, suggesting that demand was understated. Adjusting demand higher by 1 mm b/d would reduce inventories by over 400 mm barrels by Dec 31. This implies that commercial inventories would face a record 500 mm barrel deficit, while total inventories would reach a record 820 mm barrel deficit.
Super-Spiked by Arjun Murti
At first, I was going to summarize Arjun’s fantastic article — but then I realized that he had already pretty much summarized the relevant section under the subheading ‘Where Oil Prices Are Today’. Hence, I shall just copy and paste that section here in all its original glory — click the link below for the full excellent article:
Where are we today? (Link)
We currently see mixed signals on both upward demand pressures and where we are in US shale maturity. While OPEC spare capacity we believe remains limited, production creep (without spare capacity build) is possible.
DEMAND
We suggest a framework that looks at three scenarios:
"Peak demand": Oil demand growth slows to a flat-to-downward sloping trajectory in coming years due to a to-be-determined mixture of worsening energy poverty (bad) or a step change improvement in efficiency gains and new product substitution (good).
"Grind-it-out". Ongoing moderate growth of 0.75-1 mn b/d per year, as global GDP growth struggles.
"Rapid energy poverty reduction": Oil demand grows over 1.5 mn b/d per year driven by improved living standards for the other seven billion people that do not live in the United States, Western Europe, Canada, Japan, or Australia.
Our base-case oil demand outlook is closest to a grind-it-out-scenario. We hope to be proven wrong in favor of a rapid energy poverty reduction scenario leading to sharp increases in oil usage in regions like Africa, India, southeast Asia, and eastern Europe. The worse-case outcome is worsening energy poverty, a failure to achieve step change improvements in efficiency, and a recognition that demand substitution is easier said than done.
SUPPLY
From its flattest point in 2017, the oil curve has begun to re-steepen, signifying a maturing of the legacy resource base (Exhibit 6). Invariably, we would fully expect highly developed regions, such as the basins that contain US shale plays, to reach a mature plateau and eventually decline. The application of new technology can eventually lower the cost of developing inventory that today is considered to be Tier 2 or Tier 3. But the successful application of technology and resulting cost reductions do not always happen in a linear fashion.
Exhibit 6: The oil cost curve has been steepening in recent years, a sign that a new CAPEX cycle will at some point be required in the event of ongoing global oil demand growth
Open Insights
Summary
The chart above shows how OPEC+ exports tend to rebound after a period of dipping. The implication here is that OPEC+ is merely refilling spare capacity now, only to release it later. This implies that the current oil price rally could be short-term and short-lived.
However, he also point to the bottom-right chart (of the charts at the top of this article), and notes how there is a secular departure in total global inventories from historical trends. This observation would align with Goehring & Rozencwajg’s findings in their Q2 letter above.
The implication is that markets might end up waiting for a reversion to the mean over the remainder of 2H23… and keep waiting. This could keep oil prices “higher for longer”.
However, the author does caution against expecting oil prices to go and stay above $100 per barrel prior to the US election. US politicians will definitely be unhappy if that happens, which might prompt them to seek remedial actions to global oil supply such as a rapprochement with Iran — or perhaps turning that Saudi fist bump into a handshake.
The Saudis themselves also have incentive to keep foreign investors happy in order to complete their recently announced NEOM megaproject. Pushing the global economy into a recession by forcing oil prices to stay above $100/bbl might sour potential investors on making such investments — not to mention the hole it would burn in their wallets.
The long and short of it is to reasonably expect oil prices to trade range-bound at current levels; but not to expect oil prices to surpass $100/bbl continuously until the US election is over in end-2024. After that though? All bets are off.
Value Investing Substack
To wrap up this post, here’s an excerpt from my relatively recent Occidental Petroleum (OXY) report written in April 2023. It covers my thoughts about the LT supply/demand imbalance in oil markets — from a slightly different angle than the authors above have discussed. For the full OXY 0.00%↑ report, click the link below — the thesis has only gotten juicier since!
O&G Sector Dynamics — Supply:Demand Is Tight, Tight, Tight! (Link)
Balance of risks lies dramatically in favor of higher oil prices: The outlook for crude oil demand remains uncertain (e.g. China’s slower-than-expected reopening) — but what is beyond certain is the dramatically increasing tightness of global supply. If the supply situation doesn’t improve rapidly in relatively short notice, it’s not unrealistic to see oil prices spiking again in the possibly multi-year interim until demand:supply rebalances.
US shale production is in LT secular decline: Due to low oil prices and depletion of Tier 1 shale inventory, current US shale valuations are in trough territory averaging at ~0.8x net debt-adjusted PV-10 per share. This has made it more value-accretive for shale players to allocate capital towards share buybacks over drilling. DUC well levels have petered down to historical lows (as shown above) — and with new shale wells taking 3-5 months to be brought online, there is huge potential for a volatility spike in WTI prices should demand suddenly increase until onshore supply rebalances. OXY’s CEO Vicki Hollub recently mentioned that she foresees an upwards oil price trajectory in the medium-term, with the mid-cycle price of oil having since adjusted from $60 closer to $80 due to structural undersupply. Pioneer’s CEO Scott Sheffield was recently on CNBC saying that US shale production growth could fall by up to -40% within 2-3 years (from 500k b/d to 300k b/d) — with Permian unconventional (shale) production declining from 8mm b/d to 7mm b/d by 2030. Cost inflation & lower production yields in US shale (e.g. due to overlapping wells in the same drilling zone) have also driven consolidation activity in the space, encouraging the supply conditions necessary for the potential future development of pricing power.
Offshore supply has tightened beyond the breaking point: After a half-decade of lower-for-longer oil prices, yards have stopped building new rigs and have seen a dearth of skilled labor — implying low incoming rig supply. Cold-stacked rigs represents a material number of remaining global rig inventory, and cannot be put immediately into use without substantial refurbishment. Both rig buyers and rig builders are taking a “wait-and-see” approach to dwindling rig supply, as uncertainty surrounding heightened ESG concerns have made building long-life offshore rig assets a much more expensive consideration. New rigs typically take 2-3 years to build, implying that there could be a dramatic supply chain gridlock in the offshore O&G sector if demand spikes in the near-future. In the interim, Brent prices are potentially subject to dramatic price volatility.
OPEC+ put: OPEC’s recent 1.15mm bbl per day cut in their production quota despite warnings from the USA implies that there is a functional floor beneath global oil prices — many analysts think that floor lies at $80. IEA says that the latest cuts risk exacerbating the substantial supply deficit that was already projected in 2H23. OPEC had already been underproducing relative to its quota, hence the effective cut by OPEC-10 is only 0.1mm b/d rather than 1.15m b/d — but the extension of the Russian production cut of 10.5mm b/d implies a combined production cut of of 0.8-1.0mm b/d. There might also be a ‘Russian put’ as Russia has incentive to want oil prices as high as possible.
Summary: The aggregate effect of all of the above is to tilt the balance of risks for crude oil prices materially towards the upside.
The Summary of Summaries
To summarize all of the summaries above, nothing has changed in my view of the LT supply/demand crude oil imbalance since I last wrote my OXY report — and by extension, the LT trajectory of oil prices. Supply fundamentals are so woeful that I find it hard to disagree with any of the commentaries above. It’s true that it has taken 6 months since my OXY report for markets to recognize this — but 6 months is nothing when most LT investment horizons last at least 5 years!
Like G&R’s comment implied above, the last 6 months has only strengthened my belief that markets can indeed be inefficient — and can remain so for protracted periods of time. $100 oil prices over the LT? I almost cannot not believe it.
This is how value investors can earn supernormal returns over the LT — they have through lots of painful experience learned and obtained a deep-rooted belief that markets can truly be inefficient in the short-term. This subsequently gives them sufficient conviction to bet against the crowd when valuations fall to “C’MON MAN” levels relative to fundamentals, while still intelligently managing risk.
Value investors call this investing methodology ‘Margin of Safety’ — if you’d like to become a value investor and start earning supernormal LT returns as well, why not begin your journey by clicking on one the articles below?
If you’d like to thank me for this article, consider becoming a paid subscriber — or just Like this article below!
Also check out some of our earlier stock reports!
