Inflation has been an issue for some time now and oil prices are on the rise again. As you grit your teeth at the gas pump this week, You may ask yourself; how long can this go on? How do high prices resolve themselves? There is a famous quote among commodity investors that “The cure for high prices is high prices”.
No matter how complex the situation, a simple fact holds true: High prices are resolved by supply increasing or demand decreasing. When commodity prices are high, producers increase extraction and sales, seeking to maximize profit. As more and more producers attempt to exploit these high prices, the market can become oversupplied, causing the commodity price to decline. With the recent surge in commodity prices, history suggests that production will ramp up, but many are surprised to see that the price of oil has stubbornly continued to rise. Why is this?
There are numerous overhangs that may be causing prices to stay high, with a few listed below.
- Geopolitical Tensions
As of 2021, Russia was the world’s largest single exporter of Natural Gas, and the second largest Crude Oil exporter behind Saudi Arabia. Canada and the US have banned importing Russian oil, and many western producers including BP and Shell have abandoned their Russian operations completely. Those barrels will have to be made up elsewhere and, unsurprisingly, shifting production can take time. Russia has warned the West that continuing the ban could push oil prices much higher.
- Government Pressure
Both governments in Canada and the US have shown their hands, making it clear that they intend to offshore production rather than increase it domestically. With the ban on Russian oil beginning to bite, the US plans to turn to Iran and Venezuela. While you likely remember that the Biden Administration suspended drilling permits on federal land and canceled the Keystone XL pipeline as a day-one priority; we have yet to see whether this crisis will provoke a shift in Western governments’ energy policies.
- ESG (Environmental, social & governance investing)
ESG has been a roadblock diverting capital away from the energy sector, with more and more investors concerned about the environmental impact of their investments. Because of this, energy companies are not spending money on exploration or new production. Capital spending in 2022 is expected to be roughly half of the levels it was in 2013/2014, the last time oil was above $90 a barrel.
- Production Takes Time
Producing oil is not like flipping on a light switch. Reserves must be discovered, permits acquired, wells drilled, employees hired, equipment purchased etc. When covid hit, many producers had DUC’s (drilled but uncompleted wells) which have since been tapped as demand has increased. Most DUC’s that have been developed are now in production, while new exploration has been trailing behind.
Now that we have addressed the supply side, let’s talk about demand. Just like supply, demand for commodities has historically fluctuated based on the commodity’s price. As commodity prices go up, demand for the commodity decreases, and an eventual lack of consumers causes prices to decrease once more. Today, though, things are different: As oil prices continue to skyrocket, demand for oil is remaining fixed or even growing. What’s going on?
It just might be that we’ve underestimated the continuing importance of oil to the global economy: In 2020 Carbon Brief wrote, “The world has already passed ‘peak oil’ demand, according to Carbon Brief analysis of the latest energy outlook from oil major BP.” In February 2022, demand reached an all-time record for refined product.
How could we be getting it so wrong? The International Energy Agency (IEA) is responsible for “providing authoritative analysis, data, policy recommendations, and real-world solutions to help countries provide secure and sustainable energy for all”. Contrary to Carbon Brief’s 2020 analysis, the IEA recently announced the largest set of upward demand revisions in its history.
For reference, the IEA was created in 1974 to help co-ordinate a collective response to oil shortages that were faced at that time. Going back to 2010, the IEA has underestimated global oil demand in 10 of the last 12 years. How can we expect policy makers to get it right when the biggest information provider on energy is continuously wrong?
I believe there are a few reasons why we keep getting the demand side of the equation so wrong.
- Developing Countries Keep Consuming more Fossil Fuels
Quality of life increases with access to energy (in particular low-cost energy), and there are millions of people who would do anything to enjoy the luxuries that we have in developed countries. Fossil fuels have been historically the lowest cost option, and many developing countries argue that they should be entitled to the same economic benefits that fossil fuels have provided Western countries for the last 100 years. Developing countries are both unwilling and unable to jump the technology tree to renewables: High-cost solutions that require tremendous innovation and massive investment.
- Renewables are Expensive
Transitioning to renewable energy is not cheap. Rare earth materials - which, as the name suggests, are rare and expensive - are a huge part of the cost associated with renewable energy. Alongside fossil fuels, these rare earth materials have recently seen a drastic increase in price. This is another supply and demand story in itself: As raw inputs for green energy get more expensive, the technology itself will be more expensive. That includes batteries, solar panels, wind turbines, electric vehicles, and more.
- Renewables are not Reliable
When the wind doesn’t blow and the sun doesn’t shine, you don’t have power. Renewables are good for intermittent energy but are not good for base load. Battery technology, in terms of energy storage capability and cost, must improve for renewables to become more viable. In Europe alone, billions have been poured into renewables, yet countries like Germany are still extremely reliant on gas from Russia, with over 40 million German households still being heated with Oil or Natural Gas.
- Stimulus + Lockdown = Pent Up Demand
For almost 2 years people were told to stay home for their safety. Governments attempted to keep the economy moving by providing unprecedented stimulus, and as a result consumers have more money to spend than they did before the pandemic. When people have money to spend, they spend it. Especially when they have missed out on 2 years of traveling, events, and socializing. Our habits have not changed enough for the desire of those experiences to go away, and those experiences all require the same thing: Energy.
When you combine geopolitical tension with a poor plan in place to fuel our future you get the perfect storm for sustainably higher prices. Demand is not decreasing as anticipated and the supply response we normally see from producers at these elevated prices is not happening. The fragility of our globalized economy has never become more apparent than now.
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