Investing in Oil’s Last Hurrah is Risky — Oil Price Outlook

It’s been quite an interesting week for the energy market. Oil hoarded media outlets after OPEC+ failed to reach a deal.

But let me backtrack. As you know, oil prices collapsed during 2020 after all the lockdowns and border closures hit demand.

In April last year, OPEC+ agreed to cut supply by removing 10 million barrels per day of production to set a floor on prices. They’ve been keeping a lid on supply for over a year now.

And it’s worked. In the last year, oil prices have increased by over 72%.

OPEC+ had then planned to increase oil supply in August by 400,000 barrels a day, and the same amount each month until December, which would have increased supply to two million barrels a day by the end of the year.

But that was before talks broke down.

When news of OPEC+’s deadlock first reached the market, oil rallied. Brent hit over US$77 a barrel. The thinking behind it was that no deal meant supply would remain tight.

But then things went south, literally.

Oil prices dropped to around US$74 a barrel.

Why the sudden change?

Fear gripped the market. Fear that some OPEC+ members would go rogue and ramp-up production, which would then increase supply and drive oil prices down.

Now things are kind of in limbo.

OPEC+ could still reach an agreement before August hits.

If they don’t, two things could happen. Either members keep to the agreement and supply stays tight, which could drive prices higher.

Or we could see more supply coming into the market, which would drive oil prices down.

Of course, there’s a wild card here: COVID-19.

Oil prices have also been increasing over the year on the expectation that economies would start opening up and demand would increase.

Vaccines are rolling out, and it’s summer in the Northern Hemisphere. However, it’s not looking so straightforward with surging cases in Asia and Europe at the moment.

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The point I want to make here is that oil prices have been increasing over the year because oil producers have been keeping supply in check.

We can still produce more oil.

I mention this because there’s a narrative that’s been gaining ground lately.

It’s an interesting time for energy markets. It’s a sector that’s going through a lot of disruption.

There’s a ton of pressure coming from investors for high emitters to cut emissions. Oil and gas have become toxic…it kind of reminds me of tobacco companies back in the ‘90s.

But the narrative goes that with less new investment by major oil and gas companies, we could see higher oil prices and oil shortages, which would benefit oil producers.

I wouldn’t count on it though.

We may get some volatility in the price. After all, oil is an important part of the economy. But in my mind, this is a risky proposition because this is an industry in decline.

The fossil fuel industry was already in decline before the pandemic hit, COVID-19 only expedited it. It’s likely that demand never recovers to 2019 levels.

In fact, Carbon Tracker has done quite a bit of work on this:

There is a huge legacy fossil fuel system with over $30 trillion USD of fixed assets, and thousands of companies whose business plan is based on rising demand. And yet this is all vulnerable to disruption as you move from growth to decline.

Infrastructure and generation plants last for decades. As investors realise that the era of business as usual is over, so they decide not to invest in the continued expansion of the legacy fossil fuel system. The impact is felt immediately if you are a company which builds new machinery for coal plants or offshore oil exploration platforms.

Financial markets are well aware of what is going on and are exiting the most vulnerable parts of the fossil fuel system. The European electricity sector collapsed in value in 2008 and spent the next decade in massive sector restructuring and the write-down of $150 billion USD of fixed assets. General Electric’s gas turbine division took a $23 billion USD write-down in 2018 as the share price of the company fell by two thirds. Coal stocks have been falling since 2011, two years before coal demand peaked. Business models based on high power plant utilisation rates and inflexible baseload provision are not needed in this environment. The companies who are feeling the shock are those that refused to accept the pace of change or are incapable of adjusting their technologies and business models to meet the energy transition.

As far as I can tell, oil and gas companies are taking two different attitudes towards the transition. Some are actively trying to change with the transition and others aren’t doing much about it.

The former will need to plenty of cash to invest.

The latter will be more exposed.

Even if oil prices go higher in the short term, they may not profit much from that. Fossil fuel companies are facing more regulation, higher costs of doing business and financing, and pressure to invest or get left behind.

Some of what they count today as ‘assets’ may never see the light of day.

At the same time, renewables are coming. Global solar and wind capacities are increasing while costs are also decreasing…fast.

The price for solar electricity has dropped by a whopping 89% in the last decade. And of course, if the price of oil were to rise, this would only make them even more attractive.

Renewables also have plenty of advantages. They don’t pollute and they are abundant.

In short, they’re the better technology and make economic sense.

It’s true that oil still makes a major part of our economy…and we need it. Oil isn’t going anywhere just yet.

But this is a declining industry where demand is unlikely to recover to the same levels pre-pandemic.


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Selva Freigedo,
For The Rum Rebellion

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Selva Freigedo is a research analyst for The Rum Rebellion.

Born in Argentina, her passion for economic analysis started at a young age. Her father was an economist for the Argentinean governments and the family used to discuss politics and economics at the dinner table.

Argentina is a country with an unusual economic history. Growing up there gave Selva first-hand experience on different economic phenomena such as hyperinflation, devaluation and debt default.

Selva has also lived in Brazil, Spain and the USA.

Back in 2000 she was living in the US as the dot com bubble popped…
And in 2008 she was in Spain as the property market exploded and then collapsed…

She has seen first-hand what happens when bubbles burst.

Selva joined Fat Tail Investment Research’s team in 2016, as an analyst. She now writes from her vantage point in Australia, where she settled in 2015.

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