By Jack Hough
March 5, 2022
An oil chief tells me he doesn't plan to produce more barrels this year, even with Texas crude recently shooting above $110. His reasoning in a moment. Plus, a global commodities strategist says armchair explanations for why we're in this price jam are mostly off. And a pair of Wall Street banks ponder $200-a-barrel oil.
iStock-172885880.jpg
I took breaks this past week between rage-scrolling Russian convoy pics on Twitter and hollering questionable takes on NATO at the television to ask around about energy, because it's pivotal for investors now. Russia is a capital markets featherweight that previously had a smaller stock weighting in emerging markets than Thailand. And its imports to the U.S. are near squat. But one of them has outsize importance for price-setting: sour crude.
The U.S. buys Russian oil for technical reasons that are related to grade, refining profitability, and geography. One of them is that although Houston can launch men to the moon, it can't easily ship crude to Los Angeles or New York because of maritime restrictions in the Jones Act, passed in the petro predawn of 1920. There's a thoughtful case for allowing Russian oil imports that has to do with avoiding economic self-harm, and a more satisfying case for banning them that involves unprintable words and impolite gestures. It could go either way.
There were three oil spikes bigger than the current one—two in the 1970s, and one in 2008—and all were followed by recessions. A recession can mean the difference between a stock market correction, which the U.S. has already had this year, and a more painful bear market, which it has so far avoided.
The oil market was tight even before Russia invaded Ukraine. Now, even without oil sanctions, some major producers and tankers have gone on a buyer's strike to cut reputational and business risk, says Helima Croft, global head of commodity strategy at RBC Capital Markets. What about the recent release of strategic reserves? Markets shrugged it off. That basically "gets you through lunchtime in terms of our daily demand," Croft says. How about shale drillers? "The U.S. is not the country you call on when you have an immediate and sizable supply disruption," she says.
A year and a half ago, shale drillers were struggling for survival. Then travel picked up, and oil rebounded from pandemic lows, but drillers have remained chaste on production. Regular readers will recall that in January, Rick Muncrief, the CEO of Devon Energy (ticker: DVN), whose stock shot 178% higher last year, told us he's capping production growth at 5% this year. "We've had some head fakes," he said at the time of past rallies that were killed by overproduction or demand downturns.
I went back to Muncrief to see if he had found any wiggle room, given recent events. "The plan is the same," he says, and he reminded me that 5% growth is the cap—his production is more likely to be flat this year versus last year. It can take three months to drill a new rig, and Devon uses what are called multiwell pads, each with three to six wells, so if the company goes after more barrels today, it might produce them in nine to 12 months. Drillers are dealing with inflation of their own. Muncrief says he has to pay 15% to 20% more for rigs today than a year ago.
Then there's the matter of "super-backwardation"—what traders call the unusually sharp drop-off in the oil futures curve. The market expects oil prices to fall to $85 or so from $110 over the coming year, whether from pandemic kinks passing or oil buyers finding workarounds for the Russian supply disruption. Futures could be wrong, of course. But for now, production growth is expected to come mainly from private shale drillers that don't answer to shareholders. "For investors to get excited about adding barrels, the shape of the curve has to change," Muncrief says.
Have environmentalist investors pushed too hard and left supplies dry? "The biggest factor by far still is the fact that shale producers were seen as destroying a lot of capital," says Croft at RBC. Greens and oil champions, ironically, have been fighting for the same thing at board meetings: holding the line on production.
How about President Biden canceling the Keystone XL pipeline or not issuing permits for drilling on federal lands? I have a doctor's note excusing me from politics, so I'll leave arguments for and against these things to others. But they aren't especially related to the immediate oil shock. Oil is still coming in from Canada by rail and the original Keystone pipeline.
And for now, there are ample permitted but idle reserves. Side note: Croft says the Biden administration has been less clear than the Obama one about whether it supports liquefied natural-gas exports, and will green light new terminals.
The main culprit for current oil prices is slashed shale production meeting rebounding demand, and of course, a war waged by a country that produces 10% of the world's barrels. It doesn't help that some OPEC members, like Nigeria and Angola, are having difficulty meeting production quotas. There are just four countries with immediate spare capacity: Iraq, Kuwait, the United Arab Emirates, and most important, Saudi Arabia.
If high oil prices are supposed to cure themselves, but new supply will take time, how about falling demand? The problem is that the 2008 spike didn't cause demand destruction until prices were in the $140s, Croft says. That's the equivalent of around $200 today, adjusted for inflation, which is the price that investment bank Stifel estimates oil would have to see if Russia were pushed out of the market entirely. That won't happen, they conclude. In a separate analysis, BofA Securities calculates that $200 oil would slice two percentage points off U.S. economic growth.
Here's hoping for peace, new barrels, a future of falling oil dependence, and a management change in Moscow. Meantime, I've got some cable news shows to shout over.
Copyright 2022 Dow Jones & Company, Inc. All Rights Reserved.
