Musings on Oil

It hasn’t been a great year for oil stocks. The XLE is off 50% this year while the S&P 500 is close to record highs. COVID-19 has crushed transportation demand, which comprises the majority of oil consumption. The price war instigated by Saudi/Russia also made things a lot worse for producers.

Oil stocks have already had a rough decade. From the 2010-2014 period, oil prices ranged from $80-100. From 2015-2019, it averaged around $40-60. Oil companies, not surprisingly, made a lot more money in the first half the decade.

Hydraulic fracturing and horizontal drilling have helped access shale oil, increasing US production by a few million barrels a day. It helped the US achieve a greater degree of energy independence. But the increasing supply put additional pressure on oil prices.

The return on finding new oil remains low. For the past several years, it seemed like oil companies generated net income and paid dividends, but earned relatively little free cash flow.

On top of that, ESG mandates are encouraging oil companies to invest less in oil and more in sustainable technologies like wind and solar. This is particularly true in Europe. Emissions are the biggest downside to fossil fuels. They release a lot of CO2.

Finally, and potentially most devastating, the outlook for long-term demand has turned south. Just take a look at all the Teslas in any big city and you’ll get a glimpse of the future. BP has recently reported that oil demand will permanently decline from here. Peak oil? Yes, but due to demand, not supply. Other oil companies seem oblivious to the change.

Is it worth prospecting for investments here? There are net-nets among oil producers and services companies. Even the majors trade at or below tangible book value. I think the risk/reward on oil stocks is favorable.

Let’s first talk about oil’s fundamental advantages. First, it’s energy dense and relatively affordable. It is highly available with a global distribution infrastructure already in place. Oil is its own store of energy. It can be stored in tanks, in pipes, and even in tankers. It doesn’t require costly batteries for storage.

Oil is still highly strategic. Global trade depends on it. Militaries depend on it. The same is true for agriculture and air travel. There are a multitude of industrial and medical uses. There is currently no acceptable substitute for these applications.

But ultimately, it comes down to supply and demand.

On the supply side, capex levels are down. Rig counts are at record lows. Global capex for E&P companies will be in the $300-400 billion range this year. This is down from the $800-900 billion range earlier in the decade.

Negative prices earlier this year caused well shut-ins. Some of these won’t reopen. Those that do will resume production on their normal depletion curve. Shale wells typically have much higher depletion rates.

Overall, supply is down and capex is being cut. There is an extensive industry rationalization underway right now. That’s usually a good time to be buying any commodity.

The big question, of course, is demand. There are cyclical and secular factors at play. Roughly 50% of oil used is gasoline for cars. Another 8% or so is used for air travel. Vehicle miles are currently down by about 10% in the US. Air travel is down 60%.

Perhaps both will recover in the next couple years. But if air does not recover and people drive more, what will happen to oil demand? Both situations imply a fairly healthy recovery. I’m generally in the camp that things will return to normal.

And what about the long-term? Electric vehicles are the big threat. But oil has always had to contend with these threats. Vehicle emissions have been improving for decades, impacting oil demand. Vehicle emissions will continue to improve, and electric vehicles will accelerate that.

It will happen, but it will take time. There are 1.2 billion vehicles on the globe and 2.2 million electric vehicles were sold in 2019. But electric vehicle growth is accelerating, and small reductions in demand can have major impacts on price.

On the other hand, emerging market demand is still growing. Oil consumption per capita in the United States is ~900 gallons a year. This compares to ~150 gallons in China and ~50 in India.

Though the future is cloudy, it will take some time for long-term demand to be impacted. There is a reasonable case that oil demand will continue to rise for a while.

In the near-term, however, supply is down and demand could be coming back. If you believe that the post-COVID world could be anything like the the past, there could be a snap-back in oil prices. Investing in some of these oil net-nets could turn out to be a gusher.