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Oil is surging. For the first time in years, the price of West Texas crude is threatening to break above $60/barrel. Should we adjust our portfolios for higher oil prices?
Oil is surging. For the first time in years, the price of West Texas crude is threatening to break above $60/barrel.
Should we adjust our portfolios for higher oil prices?
We’ve come a long way from “peak oil.”
Not long ago, it seemed like a forgone conclusion that the world was running out of cheap oil. In 2007, had you asked 100 random folks where oil prices were headed, probably 99 would have said “higher” or “much higher.” Many professional analysts insisted that $200/barrel oil was inevitable.
Ten years later, we now know that the “peak oil” predictions were dead wrong. By the late 2000s, high prices had attracted billions of dollars of capital into the oil industry. This spurred innovation and led to the improvement of techniques like fracking.
The rest is history. Fracking unlocked oceans of oil that oilmen previously believed were impossible (or too expensive) to extract. The price of West Texas Crude (the U.S. benchmark) oil crashed from $117 in 2011 to as low as $26 in 2016. This caused a mini-crisis in the energy industry, erasing hundreds of billions of dollars in stock market wealth.
Big oil producers like Exxon Mobil (XOM, -30%) and Shell (RDS, -53%) saw their stock prices collapse.
Oil service & equipment companies like Halliburton (HAL, -60%), and Seadrill (SDRL, bankrupt) fared even worse.
Today, oil is once again showing signs of life. It has surged 20% in the last few weeks, and currently sits around $59/barrel. Many in the financial media are chalking up oil’s current rally to the political “purges” in Saudi Arabia. In what he’s calling an “anti-corruption” measure, Crown Prince Mohammed bin Salman recently made sweeping arrests of rival princes, government min-isters, and rich businessmen. Many see it as a thinly veiled play to consolidate power.
Saudi Arabia is a critical global supplier of oil - al-though not as critical as it used to be. It now ranks third in global oil production, behind Russia and the U.S.
With oil poised to challenge $60 for the first time since 2015, let’s look at some other important drivers of the oil price. What are supply and demand telling us?
When discussing oil demand, the words “for now” come up frequently.
As in, global demand for oil is growing – for now.
Most people still drive gasoline powered vehicles – for now.
Oil is still the world’s most important commodity – for now.
For now, the world still runs on oil. But that’s quickly changing. As Real Vision founder Raoul Pal said in Real Vision’s “The Big Story: Oil Up-date” on October 6 – “oil will eventually become the new coal.”
Like coal, oil is seen as a “dirty” fuel that emits a lot of carbon when burned. And, also like coal, world governments would like to phase out the usage of oil.
Even raging oil bulls acknowledge that that the importance of oil is diminishing. According to Real Vision’s The Big Story: Oil Update contributor and energy expert Gregor Macdonald, annual demand growth had averaged around 2% over the last 30 years. More recently, this number has dropped to around 1% per year. By around 2022, he believes oil demand could stop growing altogether.
Right now, electric vehicles are the biggest threat to oil demand. According to the EIA, the transportation sector consumes nearly three-fourths of total U.S. petroleum. And in the U.S. refiners rely on turning an average of 9.3 million barrels of oil per day into gasoline.
However, sales of gasoline-powered cars are projected to decline in the U.S. going forward. Meanwhile, electric vehicle sales are expected to explode by at least 35% per year.
And it’s not just cars that are going electric. Automaker Tesla recently unveiled plans for an all-electric freight truck. Tesla estimates it will save $200,000 in fuel costs over the life of the truck. Much of that will come directly out of the revenues of oil companies.
Meanwhile, governments are helping the electric car industry along. The government of India, for example, not only subsidizes electric cars; it has committed that India will sell only electric cars by 2030 – no more gasoline powered cars.
The U.K., France, and China have similar plans to phase out production of cars powered by internal combustion engines by 2030.
This all seems ominous for the price of oil. But keep in mind, the vast majority of vehicles still run on gasoline today. According to Reuters, only about 0.2% of small vehicles globally are electric cars.
In other words, we still need oil to power our cars - for now.
That’s the demand picture. What about supply?
The Energy Information Agency (EIA) projects oil supply will outstrip consumption in 2018. Further, Macdonald notes that the world produces 2 million more barrels of oil per day today than it did in 2014. In that time, the price of oil has fallen by more than half.
While Russia, the U.S., and Saudi Arabia are the “Big 3” oil producers, energy expert Gregor Macdonald notes that Iraq and Iran are important producers at the margin as they’ve always had gargantuan reserves of oil. But due to war and sanctions, they’ve not been able to produce anywhere near their potential.
This has changed recently. The two countries combined have grown production from 6.5 million to over 9 million bbls / day.
Importantly, the average cost to produce a barrel of oil in Iran or Iraq is cheap. Unlike most shale oil producers in the U.S., Iraq and Iran could potentially remain competitive with oil at just $25 - $30. The average break-even price for U.S. shale producers is thought to be around $40 - $50.
That’s a key figure that many analysts believe will serve to cap oil prices. Many shale projects are not currently pumping oil because they’re unprofitable at today’s prices. They would, however, be profitable at slightly higher levels, so these sources stand ready to come online and add to supply should the price rise.
Indeed, we’re already seeing new supply as a result of the recent price rally. According to Baker Hughes, the number of active oil rigs increased this month for the first time since July.
Overall, the long-term prospects for the oil price seem pretty grim. Demand is shrinking and supply is growing. It appears to be the perfect recipe for lower oil prices. But it’s worth keeping in mind that higher oil prices seemed like a “sure thing” back in 2007. That did not turn out well for the oil bulls. If you’re interested in putting money to work in oil – long or short – we recommend keeping these two timeless investing lessons in mind:
1) Markets often punish the consensus 2) Markets can defy fundamentals for years
In other words, oil may well be headed lower in the long-term… but it could truly go anywhere in the short-term.
As an illustration of this, consider coal. It’s dirty. Governments hate it. Regulations arein place to prevent its use and phase it out.
But like it or not, coal burning plants still produce around 38% of the electricity the U.S today. It will take decades to wean the U.S. and the rest of the world off coal.
Investors seemed to forget this as the coal ETF KOL lost 90% from 2011 to early 2016. Eventually, they realized that the narrative of coal’s demise was totally overdone. Since then, KOL has tripled from 5 to 15 – good for a 200% gain. Not bad for an industry in terminal decline.
If you’re looking for bargains in oil stocks today, you may want to start with the OIH ETF and the companies within it. OIH has badly lagged the price of oil for nearly 2 years now. Since bottoming in early 2016, WTI crude has climbed about 120%. Meanwhile OIH has only gained 20%.
It’s a similar story with the larger energy companies (ticker: XLE) and the explorers(ticker: XOP). XLE has gained only 60% since bottoming in early 2016. XOP has gained 42% in the same period.
As a result, all three of these ETFs – and many of the companies owned by them – are cheaper than they’ve been in years relative to the price of oil. So, if you expect oil prices to remain around $60 or above, oil stocks could be a good value today… especially if they begin to “play catch up” to the price of crude.
See you next week.
The US yield curve is heading south. The difference between the US 10 year yield and the 2 year yield is around 60bps, the lowest level since 2007. The yield curve has inverted (dropped below zero) before every recession since 1980. There’s still some way to go, but this is one to watch.
John Deere (DE) has looked unstoppable lately. The world’s largest manufacturer of farming equipment just closed a phenomenal third quarter in which sales grew 23% and profits grew 79%, crushing analyst estimates. This continues Deere’s stellar year, in which it has increased sales by 11% - far surpassing management’s guidance that sales would be flat to slightly down in 2017.
After years of going practically nowhere, Deere’s stock has been on fire. From 2011 – 2016, it struggled in the 75 – 95 range. But late last year it blasted above 100 and hasn’t looked back. As we write, Deere stock trades for $146, an all-time high.
While Deere enjoys near-record profits, some of its customers are struggling to stay in business. Thanks to depressed crop prices, many farmers are barely breaking even. The Rogers International Agriculture Index, which measures the prices of 20 different ag. commodities, sits within 5% of its 25 year lows.
For now, things aren’t quite as bad for farmers as they were during the 80s farming crisis. But if crop prices don’t improve, we could be headed for another farming meltdown. In May, the National Farmers Union set up a “crisis” website to help farmers who can’t make ends meet. It includes information about suicide prevention, loans, and disaster relief.
Adjusted for inflation, many agricultural prices have never been cheaper. Wheat, corn, and cocoa prices are all flirting with decade lows. Soybean oil, sugar, and coffee also remain historically cheap.
Logic dictates that cheap ag prices should help folks save money at the grocery store. But that’s not what’s happened… at all.
Food inflation in the U.K. hit a four year high of 4.2% this month. In the U.S., the price of a Thanksgiving dinner actually declined about 1.5% from last year, thanks to cheap turkey prices. But this is an exception to the long-term trend. The price of a typical thanksgiving dinner has increased by about 40% since 2004. Globally, food prices have risen 2.6% per year on average in the last two decades.
Why are food prices climbing when crop prices are dropping? One word: inflation. Increases in the other costs of mass-producing food - transportation, taxes, machinery, salaries at large food companies like General Mills or Unilever – have more than offset the decline in crop prices.
Like all prices, the price of food is determined by supply and demand. According to Harvard Business Review, global food demand is expected to rise between 59% and 98% by 2050. This should put further upward pressure on prices.
Of course, forecasting anything 33 years into the future is little better than a wild guess. Still, the trend in food consumption is clearly higher. In the last couple decades, billions of people worldwide have emerged from poverty. In China and India in particular, hundreds of millions of people who used to eat primarily grains are now eating meat on a more regular basis.
Producing meat takes far more energy and resources than producing grains or plants. So, if people want to keep moving up the food chain, farmers will need to produce more food, and they’ll need to do so more efficiently.
Then again, many developed nations seem to suffer from the opposite problem: too much food. According to Israeli Historian Yuval Noah Harari, the average human today is more likely to die from obesity than starvation.
In the U.S., the government deserves a lot of blame for the obesity epidemic. For decades, the government’s “food pyramid” recommended eating all the pasta, grains, and bread you wanted, as long as you limit your fat intake. Newer research has shown this advice to be laughably wrong.
The Lancet medical journal recently published a major study that found low-fat diets were more closely linked with death from all causes. What’s more, people on low-fat diets were more likely to get heart disease or have a heart attack. In contrast, people on low-carb diets had significantly lower risk of heart problems.
Cheap, abundant food is making people fat and putting some farmers out of business. But curiously, it doesn’t seem to be hurting John Deere’s business. As a result, the ratio of Deere’s stock price to many crop prices – like corn, soy, and wheat - are near 40 year highs.
Anyone interested in buying Deere stock should keep this in mind. Although Deere has thrived recently despite depressed crop prices, this can’t persist forever. If crop prices don’t improve, Deere management will be faced with a tough question: How do you sell tractors to broke farmers?
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questionanswer
Dear Milton
What happens when (or if) the Trump Tax Plan is passed? It seems as though we are getting close to something happening.
Well, we may finally get a tax plan passed before Christmas, but I’d be careful expecting any fireworks. The market has been on a tear at the promise of tax cuts, but both congress and the senate are deeply divided. Anything that gets passed is likely to be a huge compromise and will probably fall short of what would move the needle- and most likely fall short of what has been discounted.
I’d say be careful expecting a big pop in the market if the tax plan passed and, if we get one, just wait for the dust to settle.
Having said all that, I’m keeping my fingers crossed that the loophole for deducting furniture polishing costs isn’t closed.
That would suck.
Milton
What’s hot on Real Vision this week…
WHO
WHAT
WHERE
WHEN
WHY
HOWUnder-the-radar fund manager Alan Fournier, the founder of the multi-billion-dollar hedge fund Pennant Capital Management.
A deeply enlightening conversation between Mr. Fournier and the one and only Jim Grant, of Grant’s Interest Rate Observer
On Real Vision, as the first part of our brand-new Jim Grant interview series.
December 1st
Rare is the opportunity to hear as candid a discussion about the current state of the market, and of what it takes to pick a winning stock, from such a successful fund manager.
WHAT PEOPLE ARE SAYING“Not only has Jim Grant seen it all, he actually understands much of what he has seen! Articulate, with a dry wit. One of Real Vision’s top interviews.”– Craig T.
Mr. Fournier touches on his massively winning trades amid the financial crisis, the blind spots many institutional investors now have when it comes to volatility, and the invaluable lessons he learned from David Tepper. Mr. Fournier even walks us through the opportunities he sees presented by his single largest long holding.
