When an oil hedge fund manager decides to share his view that a number of converging factors could lead to oil prices reaching $300/barrel, it will inevitably lead to some very spirited discussions. Pierre Andurand of Andurand Capital Management helped ignite just such a discussion not long ago and it opened up the issue of global supply/demand as well as the question of just how much of a price increase the global economy can handle. He believes that both factors are such that $300/barrel oil would be a real possibility. His theory is that all the talk of EVs killing oil demand is leading to under-investment in projects with a longer lead time, therefore, we could see a dramatic supply crunch within a few years, which will be the main factor that could lead to the worst oil price spike ever. I personally think that he may be mistaken because there are a few factors which would blunt the effects of the factors that might otherwise indeed lead to such a dramatic oil price spike.
On the issue of future supply/demand, I tend to mostly agree with Mr. Andurand. There is a lack of new conventional oil discoveries, which could put a serious strain on supplies. Although, I do not necessarily believe that it is mostly due to under-investment, but rather due to geological factors. In other words, we already discovered most of the conventional oil we will ever discover.
Companies are not investing enough in projects meant to increase the amount of oil that is being extracted from existing conventional fields either. In other words, few new fields coming on line, while existing fields are perhaps not exploited to as great an extent as they would be if oil prices would be closer to $100/barrel. The under-investment environment that started in 2015 is likely to start having a significant negative effect on supply going forward.
Note: Above chart is for global upstream CapEx and it includes both conventional and unconventional spending.
While it is true that a convergence of the effects of a lack of new fields being brought into production and older wells not being pushed to produce more oil might happen within a few years, causing a shortage in conventional supply, we should also keep in mind the fact that shale oil could potentially respond to an oil price spike with massive new supplies within a matter of months. It might not be enough to make up for a significant decline in conventional oil supplies, as well as growing demand, but it might just be enough to blunt the effects of oil supply shortages from other sources on the global oil price. In fact, shale oil has been doing this since the middle of 2016, with about 2 mb/d in extra production added to the global supply since then.
The increase in US production that we see represented in the chart since the middle of 2016 is in response to oil prices rising from the low of about $27/barrel for WTI at the beginning of 2016 to the current levels of almost $70/barrel. At current price levels, we are starting to approach the point where perhaps some of the better second-tier acreage in the main shale oil plays is starting to approach drilling cost break-even levels. If oil prices will continue to approach the $100/barrel mark, I believe that we will likely see an intensification of drilling in some of the second-tier acreage which has been largely abandoned since the 2014 oil price collapse. This, in turn, would lead to an intensification in the pace of increase in US oil production. While shale oil would most likely not be able to stop the increase in oil prices on its own, it could slow down the pace of the price increase, which should change the nature and shape of the economic reaction to the oil price increase.
The Economic Reaction To Rising Oil Prices
There is, of course, a huge difference between the oil price spike from current levels to perhaps $300/barrel happening within a short period of time, before the economy can fully react and a more gradual march towards such a price, where the higher prices would have a chance to work through the economy. As I pointed out already, the almost immediate reaction of shale producers to higher prices would most likely be an immediate and dramatic increase in drilling activity, with acreage that has been shun since 2014 most likely getting to see some action again. As we know by now, it only takes a few months between a price signal telling shale drillers to start drilling more intensely and the oil finding its way on to the market. What this means is that any oil price increase will most likely be very gradual.
Mr. Andurand pointed out in his analysis that $100/barrel oil is not likely to lead to demand destruction. I believe he may be mostly right. While there should be some minimal effect on consumer spending habits and some inflationary effects working through the economy, I don't believe that the road to $100/barrel oil will lead to a demand destruction event. I cannot say the same about the road from $100/barrel oil to $150/barrel, which is where I expect to see enough of an impact in terms of demand destruction that it will most likely lead to a global recession.
Based on past data, if we will see a move in oil prices from the current $70/barrel for WTI to $150/barrel, it would most likely translate to an increase in the price of gasoline at the pumps of about $2.00/gallon on top of the current average US price of just over $3.00/gallon. The obvious take away from this is that the average typical two-car family will see their monthly gasoline bill increase by about $100, which for many families it would mean more or less the equivalent of losing the extra money we see from the new tax cuts. The total effects in terms of how it would work through the economy go way beyond this very obvious primary impact meaning that we have to add it all up.
As we can see, the last time we briefly approached oil at $150/barrel in 2008, the retail price of gasoline also surpassed the $4.00/gallon level. If the price of oil would have remained near that peak for a prolonged period, the average price of gasoline would have probably eventually reached $5.00/gallon, but that oil price spike was very brief, which is what prevented the price of gasoline from reaching and surpassing such a historical level. The increase in oil prices did, however, stoke legitimate fears of inflation as it would do so this time around as well. Higher oil prices could, in fact, lead to an increased appetite on the part of the Federal Reserve to increase interest rates, which would, in turn, put a further damper on economic activity.
Inflation stemming from higher oil prices could lead to a decline in economic activity, even if it will not lead to higher interest rates. Certain consumer goods in particular such as grocery prices increasing could lead to consumers dramatically cutting back on spending on other goods and services. I believe this did happen in 2007-2008 as oil prices spiked. According to Federal Reserve data, US consumer spending did peak in November 2007, while the oil price peak happened half a year later in June. There are, of course, other factors which may have played a more significant part in the decline in consumer spending, after all the housing crisis was unfolding, but I do think that oil prices also played a part in perhaps aggravating the situation. With more household money going out on basic needs such as gasoline and food, even those who perhaps felt safe from job loss may have been more cautious in deciding to purchase big-ticket items. I suspect same will be the case again once we surpass $100/barrel and we will head higher, just as Mr. Andurand is predicting it will happen within the next few years.
As I pointed out on many occasions in the past, I built a significant stake in oil producers in late 2015 to early 2016 as a means to position myself for an oil price rebound. I bought Chevron (CVX), Shell (RDS.A) (NYSE:RDS.B), and Suncor (SU), with all three having two things in common. They are all large companies, diversified into upstream to downstream operations, which makes them more resilient in the face of what I always knew it will be a very uncertain path towards higher oil prices. The second thing that they have in common is that they pay a decent dividend. I figured since the timing of an oil price recovery is likely to be very uncertain, I might as well get paid for waiting. While the timing continues to be uncertain going forward and I do not believe that we will see $300/barrel oil, I do think that we will most likely see oil going past $100/barrel in coming years. While it goes without saying that when we reach that point, we will have to continue watching the supply/demand situation very closely in order to determine whether it is time to take profits or stay a while longer, I do believe that it is a good time to at the very least start reducing one's position in oil stocks. If prices continue to rise beyond $100/barrel heading towards $150/barrel, I think that will be a good point to liquidate most if not all of one's position in oil. While I may change my mind based on any new evidence along the way, based on what we know right now, it seems like a sensible way going forward.
Disclosure: I am/we are long SU, CVX, RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.