This article is about the President of Strategic Economic Decisions Inc., Woody Brock’s recent work on the oil market. Woody’s recent essays have formed the basis of our previous two conclusions. Those interested to know more about him should visit SED’s website: www.sedinc.com
The essay we are looking at is entitled “PROSPECTS FOR THE PRICES OF OIL AND METALS – An Application of the New Supply and Demand Logic”. We are concentrating on just The Prospect For The Oil Market, an essay of seven pages; so we will be limited to cherry picking but from what is a very well presented fruit salad!
To start, he explains that the oil market has fundamentally changed, now it is ‘market-based’ rather than ‘cartel-based’. This is because the share of output accounted for by OPEC members has shrunk to about 35%. It will be impossible in the future for OPEC to control the price of oil when only one third of the world’s producers must bear all the burden of the adjustment for everybody else.
The changing oil market: demand shock
• The Chindia-driven demand shock lying ahead is increasingly “in the market”. Investors having come to terms with the profound change, represented by the ascendancy of some two billion newcomers to the global middle class. But very importantly, Woody points out that the true magnitude of this demand shock is not yet properly in the market due to the widespread lack of understanding of the non-linearly increasing ‘base weight’ of Asian demand in the calculus of global GDP growth.
To explain this a little more clearly, if Chindia’s GDP grows at 9% per annum, whilst the developed world’s GDP grows at 4% per annum, the impact of Chindia’s demand is increasing more speedily relative to the developed world. China is already the third largest vehicle market after the US and Japan, with 31 million cars. It has been estimated that there will be 100 million cars and trucks in China by 2013. Their demand for oil therefore will increase by a factor of about three times in a global market where elsewhere the rate of demand-growth would have been much slower. If China’s demand for fuel is three times greater in 2013 than now, the increasing impact on total demand has not been properly realised.
The changing oil market: peak oil and underinvestment
Supply, of course, is the other side of this equation and here Woody says that the supply shock that SED anticipate is not yet in the market.
• Fifteen years of underinvestment in infrastructure will cause production bottlenecks.
• Nearly two decades of underinvestment in new production will continue to restrict future output.
• The accelerating ‘peaking’ of old oil is no longer a speculative hypothesis but a reality.
• The magnitude of new supplies will be increasingly offset by the peaking of old oil. It is increasingly recognised that huge new discoveries will be needed. Yet not one has been made since the early 1970s.
• Last and most serious:
“The incentive structure of the entire industry may be going to hell. To see this, first consider the claim by pessimists that we are ‘running out’ of fossil fuels. Are they right? Of course not. The world has never run out of anything and never will. At a high enough price, there is always more of anything. But given recent changes in the incentive structure of the global energy industry, prices may have to rise significantly if there is to be enough more. [The Paris-based IEA claims some $18 trillion of investment in new exploration and development will be needed during the next two decades to meet projected demand. Yet they are silent upon the price at which such an investment will be forthcoming. And so far it has not been forthcoming. Like everyone else, the IEA fail to construct the relevant supply curve for the industry.]”
The changing oil market: political risk premiums
The reason for this state of affairs is, according to SED, soaring political risk premium as a shift of new exploration moves to regions of the world that are unstable and often governed by ‘thugocrats’ (a regular theme of Woody’s is that a great deal of the world is run by thugs – and we agree). Those companies, such as BP, who have the capital and the managerial and technical know-how to undertake these investments are disinclined to pay bribes and are themselves, unbribable. They are therefore increasingly unwelcome at the bargaining table.
Even though such contracts may be set up with the current group of politicians, the risk is that they will be torn up by the next group of politicians.
• A final disincentive lies in the rise of environmental concerns.
To conclude, Woody says that a much higher price for oil will be required to produce any given quantity of output than was needed in the past to produce the quantity. This implies much higher prices of oil for any given level of demand than in the past.
Volatility won’t go away, in fact it will be a constant theme of the oil market; however, such volatility will be in an upward trend. In other words, even though prices will continually revert to the mean, the lows of oil experienced in the past will not be revisited. Each successive low, as the price reverts to its mean, will be higher than previously. Hey – that’s a bull market!
We are very comfortable with the case Woody makes and don’t doubt his explanation of the fundamentals. It is all the more interesting because the valuations, put upon the oil companies, do not allow for what is going to happen. This will mean a series of regular re-ratings as ever greater value will be put upon oil companies as their future earnings are underpinned by what is the most extraordinary global phenomenon ever – greater even than the first industrial revolution.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/