Oil be back?

Oil be back?

July 15, 2021

12:30 am

  • There are numerous instances of households and taxpayers eventually having to carry the can for government policy which was either misguided at inception or turned out eventually to be so. A prime example of this is the European Commission’s (EC) decision to promote diesel cars following the 1997 Kyoto climate agreement. The Kyoto accords demanded a reduction in CO₂ emissions, diesel engines emitted less CO₂, so with the help of tax incentives on diesel car purchases, the Kyoto goals were in part achieved. Europe went diesel – for example the UK non-commercial vehicle fleet went from 10% diesel in 1995 to around 40% by 2012.

  • The problem with diesel engines is that despite emitting less CO₂, they emit far larger amounts of NO₂ and heavy particles which contribute to breathing difficulty and asthma, particularly in children. The photograph below was used to illustrate a 2017 New York Times’ article entitled ‘A Push for Diesel Leaves London Gasping Amid Record Pollution’. Clearly this EC policy proved to be a disaster, and it was not just people’s health which suffered – subsequent rule changes restricting diesel car access in cities resulted in falling residual vehicle prices, hurting consumers in the pocket as well. So much for central planning.

 

  • Climate change is still front and centre of the political agenda, but since the diesel ‘card’ has now been played and proved to be a joker, the next move is to replace ICE (internal combustion engine) cars with EVs (electronic vehicles). The new direction of global policy strategy is however a root-and-branch one which involves not only changing the manner in which energy is consumed (electric cars, green boilers and central heating and so forth), but also how that energy is generated.

  • ‘Green’ energy policy involves the promotion of renewable energy sources such as solar, wind and tidal. Its handmaiden is ESG investing, which is increasingly pressurising corporations across the spectrum not only to promote equality and fairness in the workplace, but also to implement environmentally friendly corporate planning and policy. This is where things start to get interesting as it marks the frontier between the political aspirations for dealing with climate change and the harsh realities of economic logic with respect to energy consumption.

  • In a remarkable move back in May, the International Energy Agency (IEA), the official body of the oil and gas industry, called for an end to new oil and gas exploration, retiring coal-fired power stations in developed countries by 2030 and the banning of new sales of ICE vehicles by 2035. It is the proposed moratorium on exploration which is the key policy proposal here. This would end any debate about peak oil demand, because if supply disappears, demand ceases to matter.

     

  • Like money and credit, energy is one of those things that doesn’t really fit into classical economics that well. Rational agents pursuing their own self-interest with respect to scarce resources don’t really have time to stop and think about energy as anything more than an input cost, let alone as an environmental cost. The graph below, courtesy of the Bank of England website, shows per capita GDP for the last 3000 years. From a dead flat line for about 2750 years, things start to tick higher in the eighteenth century before heading vertical.

Source: Data and Delong, as at 1998

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

 

  • If one wants to show how critical energy is to economic growth, one should start with the inventions of the likes of Arkwright, Newcomen and Watt during the ‘industrial revolution’. The industrial use of steam power replaced manpower and horsepower. The massively higher energy density of fossil fuels like coal, tied to huge advances in productivity through technological development which were in part both cause and effect of the energy revolution, propelled per capita GDP higher as the graph above shows. At its heart, the first industrial revolution was a revolution in energy transformation. Folk like Marx who spent the nineteenth century dwelling on the labour theory of value were clearly not only wrong but also anachronistic. Organised ‘labour’ may have been a socio-political phenomenon, but as an explanation of how economics worked it was totally outdated. The advent of steam power meant the labour input of individuals clearly mattered far less during the industrial revolution than it did before it. So much for historical determinism.

 

  • This brief foray into the lesser-told historical aspects of the industrial revolution is a useful reminder of how important energy is to the economy. Start messing with it, and you may have some serious consequences. The drive towards ESG-friendly investing is starting to make itself felt at a board-room level, and this should be a concern for investors.

 

  • On the 2nd June 2021, activist hedge fund Engine No. 1 led by Chris James secured three board seats at US oil major Exxon (ticker XOM). Although managing only $240mm of assets himself, through his extensive contact network Mr James managed to secure the support of other major shareholders with the promise of a fossil-fuel free future (‘Engine No 1, the giant-killing hedge fund, has big plans’ Financial Times, 03/06/2021).

 

  • The US shale industry was crushed by the Covid-related shutdown in 2020, and with the sort of pressure not only from activist investors like Chris James but now explicitly from industry bodies like the IEA, the funding of new exploration and capex projects is becoming increasingly difficult. The oil majors are also being driven towards more renewable-related projects. This has huge implications both geo-politically and economically.

 

  • Despite all its malinvestment, the US shale boom made the US into an energy exporter, and this extra supply has helped to keep a lid on energy prices and any inflationary pressures resulting from them over the last decade. With the energy investment world moving so decisively against fossil fuels, these trends are changing. As the US potentially relinquishes the role of marginal supplier, that supply-side influence may now revert back towards the middle east and Russia. Given all the recent focus on inflation and the 1970s, it is worth remembering that it was OPEC’s moment of self-realisation that it was the price-setter that led to the first oil crisis in 1973. This is how political movements such as the greening of the world economy can end up creating unintended consequences by inadvertently redistributing geo-political power, in this case the price-setting power of oil.

 

  • While the 1973 oil shock was due to OPEC acting in unison to hike prices, OPEC today (OPEC+ which includes Russia and a few other affiliates) finds itself in a far more fractious state. The most recent meeting ended without any agreement on production increases and with Saudi Arabia and the UAE barely on speaking terms. Hopes had been of a 500k per month production increase to year end. Currently OPEC+ is producing 5.7mm bpd (barrels per day) below the baseline, so supply has lagged demand by some 2mm bpd. Some industry analysts such as Goldman are suggesting the supply deficit could be as high as 5mm bpd by year end 2021.

 

  • Oil is the supply-and-demand driven commodity par excellence. Hints of a global slow down (US macro data looking a bit iffy, tightening in China’s credit markets and so forth) all hint at lower demand, and this may offset the large inventory draws currently being experienced. Speculation too plays its part in the oil market – any sell off in global market as a result of a liquidity event (such as that following the Fed tapering its quantitative easing programme) could also push prices lower. It is also possible that a total breakdown of OPEC+ could see a production increase as quotas are ignored.

 

  • What is interesting however is how much oil has risen even with the global economy still not fully reopened. Travel and tourism have not fully recovered, and many employees are still WFH so aren’t travelling so much. The graph below shows West Texas intermediate (WTI), currently trading around $73.50 but up over 50% year to date and now significantly higher than pre-pandemic levels despite the economy having not fully recovered.

Source: Bloomberg, as at 12th July 2021.

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

 

  • Absent a wider market or economic collapse, supply issues relating to OPEC+, demand pressures from reopening, as well as the possibility of the velocity of money rising as the economy recovers and business practices normalises, all occurring to the backdrop of a US investment milieu which is increasingly hostile to fossil fuels investment, could create a heady mix of factors which could push oil higher, potentially up above the $100 mark

 

  • The effect of higher oil prices on the US and wider global economy cannot be overestimated. Along with food, gas is the biggest factor which affects how the public think about the cost of living. Oil is a ‘headline’ not a ‘core’ component of inflation, but nonetheless it could prove a critical battleground in the de-anchoring of inflation expectations. This in turn could seriously undermine the narrative from central banks such as the Fed and the ECB with respect to inflation being transitory. As an input cost, energy is a key component when calculating corporate profitability and household disposal income.

 

  • Investors should also be aware that the aspirations for greening the economy and the demands of ESG investing could prove too optimistic, and the world may in fact have to rely on fossil fuels for much longer than is hoped for. This may create good investment opportunities, but where sectors have been starved of funds, however well-intentioned the cause, the net effect of underinvestment is as much of a concern, especially given the potential impact on commodity prices, particularly oil.

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