The Energy Conundrum

Everyone watches oil prices, and for a good reason: nearly all goods and services produced in the global economy require the use of some energy during the production or sales process. And so even though the energy sector has been diminishing in importance within the investment world (the weighting of the Energy sector in the S&P 500 is less than half what it was in 2007-2008), energy prices – especially for fossil fuels like crude oil that provide the vast majority of our energy – should never be too far from mind for even the novice investor.

Some of us are old enough to remember the oil shocks of the 70s, even if only as children. Certainly, the impact of this crisis has remained on the national psyche for decades, and the threat of rising oil prices evokes a visceral collective memory of gas lines, recession, and the hallmark of the 70s: stagflation. During these years, most had accepted the premise that the world had passed “peak oil” as fields developed in earlier decades were playing out and exploration was increasingly less productive. But the term “peak oil” turned out to be a fallacy. It seems that nobody was aware of the vast discoveries yet to be made!

The United States of today is, as regards to energy consumption and production, a very different country than that of 45 years ago. Armed with new technologies like hydraulic fracturing and horizontal drilling, the US has become the largest oil producer in the world. Domestic production has doubled from a low of 5 million barrels per day in 2008 to a new record of over 10 million barrels per day this year. Many believe that the US is on the verge of becoming completely energy independent, which has dramatic implications for not only the economy but also national security.

Source: U.S. Energy Information Administration

The combination of a massive production surge in the US and lackluster global economic growth contributed to a collapse in oil prices from late 2014 to early 2016, when the oil price fell over 70% from peak to trough.  Following that time, there was a sustained period of calm in the energy markets as the price of a barrel traded sideways at relatively low levels for about a year and a half.  But over the past year, the oil price has headed steadily higher from the $50 level to over $73 today (WTI spot prices) – not an insignificant move.

With energy prices on the rise again due to supply factors outside the US, the domestic energy industry looks set to grow and thrive.  Rising oil prices brings increased employment opportunities, revitalization of communities in the “oil patches” that dot the US, and, yes, investment opportunities. But rising energy prices have an inflationary effect throughout the economy as well.  We obviously see the increases at the pump, but transportation and manufacturing costs increase too.  These increases in costs can lead to more widespread inflationary pressures across the economy.  And it is often true that higher energy costs and their ripple effects can impact low- to moderate-income folks the most as these folks have less disposable income to cushion the blow.

So, the 10m barrel question is this: Are rising oil prices good or bad for the American economy? Like virtually all economic questions, the answer is more complicated than the question.  The threshold at which the inflationary headwinds (and real economic hardship brought on to some American families) outweigh the economic benefits obviously cannot be defined with precision.  But my feeling, and the feeling of most of the experts I speak with, is that we are close to that threshold.  With $70+ per barrel for West Texas Crude, US oil fields are at high utilization.  The price, at these levels, justifies further exploration and therefore more capital spending and jobs.  But if prices climb too much higher, we may start to see a real impact on those most vulnerable to rising inflation.

Where do oil prices go from here? The fundamentals are not obvious, and that concerns me. With disruptions in OPEC supplies due to the resumption of sanctions against Iran and the collapse of the Venezuelan oil industry, there are clearly supply issues.  Saudi Arabia says it can increase production by 20% to make up for the shortfall, yet KSA has never pumped significantly more oil than they are today.  A 20% production increase at will seems a bit implausible.  As noted, US oil production has ramped nicely, helping to alleviate the supply disruptions.  But there are some analyst who believe that US production will begin dropping again, perhaps as soon as 2020, as productivity in the Permian Basin, Eagle Ford, and other fields falls.

There are other complicating factors.  Iran has begun shipping oil that isn’t easily tracked.  As of last week, 13 supertankers filled with Iranian crude had turned off their GPS transponders so the oil shipments couldn’t be tracked. When markets lack transparency they can become subject to a good deal of volatility and speculation.  In 2014, I questioned why oil was trading at well over $100 a barrel on the spot market.  Production, production capacity, and demand were all substantively the same compared to when oil trading at much lower levels.  So why was it worth half again as much? No matter who I asked the question, I never received a fundamentally sound answer, and in the summer of 2014, prices collapsed.

For now, we remain, if not in a “Goldilocks zone” for oil prices, at least a good place.  There is debate about the possibility of a move back to $100 a barrel among experts.  Most notably, this past week BAML posited we could see another 2008-style price spike.  But the next day, Goldman Sachs said that prices will stabilize, and even drop back a bit by year end.  For now, anyway, it is steady as she goes. We remain cautious, looking for signs of a price shock either up or down – either of which have serious negative implications for the economy, and thus to the markets.  Stay tuned!