In today’s Exponential Investor

  • OPEC’s challenge
  • The oil majors’ challenge
  • Investors’ opportunity

The old idea used to be that there was no cure for high oil prices like high oil prices, because people would rush to supply the market.

In a market for a single good such as oil, this works.

If you see oil double in price, you race to find more to sell it. And it really makes sense, when you’ve got customers who absolutely have to buy oil and its byproducts.

But that narrative no longer holds water.

Why not?

Because there is, for the first time in almost a century, a huge change.

Now we have something called demand destruction.

Essentially, consumers are now able to switch away from fossil fuel-powered applications and power sources. The higher the oil price goes, the more people will be nudged into buying an electric vehicle (EV).

Oil is now one product among many, and as such, is now subject to new rules.

The hard numbers speak for themselves.

Across China, the US, and the EU, EV sales surged 160% in the first half of 2021, even after a bumper year in 2020 (despite the lockdowns).

In March or 2020, Tesla was the top selling automaker in the UK for the first time ever.

Oil has never faced the threat of substitution.

Now it does, so what should oil producers do?

Catch 22 for OPEC

I have always wondered what the stronger impulse is – the need for oil companies to remain profitable or the need for their product to compete with electricity.

The former needs prices to rise as demand falls gently away.

The latter needs lower prices in order to try and stimulate demand.

OPEC – the group of major oil producing nations – members are currently sitting on 6-7mbpd of added capacity.

They are choosing not to unleash it on to the market, happy with the kind of prices we haven’t seen in a while (around $80 per barrel).

But what if they should really be flooding the market to get $20-$40 per barrel oil, in order to slow the transition away from expensive fossil fuel appliances to cheaper EVs.

For this reason, there is an important thing to consider about the oil market going forwards.

Oil companies are unlikely to allow prices to go either too high or too low.

Everyone is looking at shale production in the United States which is falling, but OPEC is set on plenty of capacity, according to the International Energy Agency (IEA – a Paris-based thinktank).

So unless there is a genuinely astronomical and prolonged demand surge, the major oil-producing nations (including, but not limited to OPEC members) have it in their power to broadly control the price.

In fact, demand destruction is a real threat now, and it is almost certain that OPEC knows it.

Why the oil majors have really been reluctant to explore

Another common refrain at the moment is to point at the green movement, and the politicians who have subscribed to the necessity of fighting climate change, and to blame them for rising fuel prices.

Politicians and ESG (environmental, social and governance criteria) are not forcing the deliberate underinvestment in oil which is going to lead to shortages and price volatility.

Economics is.

Let’s take a look at the decision-making process for finding extracting, refining and selling a new source of oil…

If you’re on a panel deciding to invest in an oil project, you will see the 25-year payback required and wonder whether you will actually break even in time.

With demand falling, such long-term bets have greatly increased in risk in the past few years.

Oil companies can no longer rely on the mantra of eternally rising demand, because a big competitor has emerged to fossil fuel-powered motor vehicles.

So, it’s vitally important to remember when you read (and you will, many times) that the green movement and political madness are to blame for underinvestment in fossil fuels.

They are not.

The oil majors are making a rational response to the problem of long-term exploration for an asset that is becoming harder to sell.

In fact, many oil companies won’t be able to maximise the value on the assets they are currently drilling, let alone new ones they haven’t even found yet.

This is called stranded asset risk, and threatens the valuations of all major oil companies, which are calculated off the reserves they hold, much of which will/must never hit the market.

So wonderful is this under-appreciated truth that someone even did a rap explanation of it, at COP26 no less!

You can see it here. It’s actually really excellent (the analysis more than the rap, I admit).

So, what’s the bottom line?

All this suggests that the oil price should dwell somewhere between the price, which is so low it makes the majority of oil companies unprofitable, and the price at which demand destruction through consumer switching becomes an acute problem.

My best guess for this is $40-$100 per barrel, which is, frankly, useless to most investors with shorter time horizons.

But it is useful in one way – it should help prevent you from buying into the mistaken idea of a great bull run in oil.

There will be trading opportunities along the way, for sure. If investors get carried away and push prices too high or too low, it’s reasonable to bet on mean reversion (that the price will return to this range).

All the best,

Kit Winder
Co-editor, Exponential Investor

PS If all this sounds about right to you, then congratulations. You have the chance to invest in the potential winners of the future, not the stranded assets of the past.

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