I’ve explained my reasons for staying on the sidelines of the oil and gas market several times. But, as Ayn Rand advocated, I like to check my premises. So I decided to interview an oil and gas expert I know from my Casey Research days, Chad Champion of The Champion Investor.
NOTE: I didn’t tell Chad what my thoughts were, so I was happy to see his independent judgment meshing well with my own.
L: Are you bullish or bearish on oil prices in the near- to mid-term? Why?
CC: I’m slightly bearish in near- to mid-term. The latest EIA short-term energy outlook talked about the bullish sentiment with the money managers’ ratio of long positions to short positions in both Brent and WTI futures contracts being the highest since 2011.
If you’re a contrarian at heart… it’s a good short-term contrarian indicator suggesting lower oil prices in the near- to mid-term. The smart money made a fortune already with oil up about 180% since hitting its bottom of $26 in February 2016.
The latest price movement suggests they’ve already started taking money off the table after oil hit close to $73 per barrel (/b) in late May. Oil is down about 12% since then.
I’ve seen forecasts ranging from an average of $50–$70/b through 2019. Saudi Arabia and its Gulf allies are looking to increase production by about 300,000–400,000 barrels per day (b/d), mainly due to pressure from the US and other large consumer countries as gas prices have started to creep up. Even Russia has suggested boosting oil by 800,000 b/d—mainly because most of their companies are private oil companies and want the money.
Throw in US shale, and there’s a lot of oil out there. We broke 10 million barrels per day (MMb/d) back in November for the first time since 1970. The EIA projects US oil production will average 10.7 MMb/d in 2018, 11.9 MMb/d in 2019, and cross above 12 MMb/d by the end of 2019.
One more thing… the number of drilled but not completed (DUCs) wells in the US keeps rising too. The number of DUCs is up over 3,000 since the summer of 2014 when the oil bear market began.
The bottom line is that there’s a lot of oil out there right now. Think of all the geopolitical turmoil in the Middle East over the past few years… Syrian War, Yemen War, two Iran sanction regimes. All that and prices have remained below $80. We could easily see oil at $50/b again.
Interestingly enough, Harold Hamm (CEO of Continental Resources, and a big shale player) has said oil needs to be above $50 to be sustainable for shale producers. And prices below $40 would cause drillers to shut down rigs again. I would use those prices as a floor.
L: How about natural gas prices in the near- to mid-term?
CC: I was talking to the CEO of a company that trades natural gas recently. He told me he is bearish on natural gas over the next 1–3 years, and sees it slightly trending up after that.
Richard Kinder, the CEO of Kinder Morgan [disclosure: Chad owns shares of KMI] laid out a long-term bull case with facts and details for natural gas back in 2015. It’s worth noting that KMI has the largest natural-gas transmission network in North America. They move about 40% of all gas consumed in the US.
In short, demand is projected to increase by 40% by 2025. He talked about four main drivers.
The first is electricity generation as more primary sourcing goes to natural gas and less to coal. Natural gas exceeds coal now in the power-generation mix… about 33% compared to 32%. The EIA projects that mix to change to 39% natural gas and 18% coal by 2030.
The second driver is exports to Mexico. Net export demand in billions of cubic feet per day (Bcfd) is projected to increase by 40% through 2022.
The third driver is the petrochemical boom. Global chemical demand is soaring, with close to $200 billion in projects in the works. The Saudi Crown Prince Mohammad bin Salman bin Abdulaziz Al Saud was just in Houston recently signing petrochemical deals worth billions.
The fourth driver is liquid natural gas (LNG). LNG net export demand is projected to increase by 525% by 2027.
We have about 100 years’ worth of natural gas based on current demand. The IEA estimates that about 40% of the world’s gas production growth will come from the US. In short, natural gas will play a key role as the world pushes for cleaner energy sources over the long term. It has about half the CO2 of coal and about 30% less than fuel oil.
L: If countries like Japan were to completely phase out nuclear power and replace it with LNG, how long would that take?
CC: They could do it immediately. Remember, in the immediate aftermath of the Fukushima accident, Japan idled all 54 of its nuclear plants. A few of those have started to come back online. The latest number I saw is that nuclear is about 2% of Japan’s electricity now. Prior to Fukushima, it was about 30%.
Needless to say, electricity prices soared to unsustainable levels. The current government plan is for nuclear to provide 20–22% of its electricity by 2030. But that’s pushing it.
One interesting development is that Japan is one country that has embraced coal in the midst of their energy crisis. They have plans to build 45 new thermal-coal power plants and are backing new coal technologies. It’s something most people don’t know, but Japan is the “world’s leading public financier” of global coal plants and technology.
L: Hm. Okay… but Japan is an island. Is LNG viable for a landlocked country?
CC: Yes. But it would be costly. Japan’s imports of LNG soared after Fukushima. It now represents about 40% of power generation. But I’m not sure it would be prudent domestic policy for a country like Japan to depend on one source of energy. Or for any country to depend on an outside source for its energy needs.
The major economies of the world understand what the two major oil shocks did to their economies in the 1970s. But Japan experienced a third with the Fukushima accident. Its people and its government have had to rethink its energy mix in the 21st century—something other developed economies haven’t been forced to do… yet. Whether it weights priorities towards its security, its commitment to the Paris Climate Agreement, or other international relations concerns remains to be seen.
Fossil fuels make up about 75–80% of its energy mix right now. It gets about 80% of its oil from the Middle East and 24% of its LNG from there. So it’s basically feeling the pains of relying one source of energy right now. The US shale boom will help it diversify its sources of energy over the long term. Regardless, relying on one source works while prices are low, but it will get ugly when prices go up.
L: Speaking of the Middle East, with OPEC voluntarily reducing output by more than Venezuela’s entire pre-crisis production, does the implosion of Venezuela matter to oil prices at all?
CC: No. Venezuelan production has been falling since 2015 to about 1.5MMb/d. Oil prices have tanked along with it. It’s projected to fall to 1MMb/d by the end of 2019. But as I mentioned earlier, US shale, the Russians, and Saudi Arabia can handle the current supply.
L: With plenty of countries willing to ignore the US and buy oil from Iran, do the new Iran sanctions matter to oil prices at all?
CC: No—for the same reasons it doesn’t matter with Venezuela. Plus, the top four export customers for Iranian oil are China, India, South Korea, and Turkey. They make up about 70% of Iranian oil exports.
China and Turkey make up about 35%. I don’t see them toeing the line. Of course, we know exemptions will be given if countries significantly reduce imports just like the last time. China, India, and South Korea were beneficiaries then.
India is the second-biggest importer next to China. They cut imports by about 20% last time to comply.
So, you’re spot on about countries willing to ignore the US and still buy oil from them. This time around, current trade disputes could magnify that.
That’s especially so if Iran continues to abide by the Joint Comprehensive Plan of Action (JCPOA), which imposed nuclear restrictions that Iran accepted in return for the lifting of sanctions). If Iran acts in good faith and still abides by that agreement, those countries will ignore the US. If Iran goes back to building its nuclear program, then it will be hard for those countries to justify buying from Iran.
But… it’s important to remember that President Obama initiated the first round of oil sanctions on Iran back in 2012. That was a few years before the JCPOA agreement took place. When he put those sanctions in place in 2012, his exact words were: “There is a sufficient supply of petroleum and petroleum products from countries other than Iran to permit a significant reduction in the volume of petroleum and petroleum products purchased from Iran by or through foreign financial institutions.”
Oil prices traded in a range around $85–$100 from then until 2014. Then prices fell close to 80% over the next few years. Those words still accurately describe the supply situation.
L: With the world stampeding into electric vehicles (EVs) at an accelerating pace, how long do you think Big Oil—the industry as we’ve known it for decades—lasts?
CC: The supermajors aren’t going anywhere. Big Oil is really becoming Big Energy. They’re full of engineers and scientists trying to find innovative energy solutions.
Not to mention they are up there as some of the most profitable companies in the world. When oil prices are high, they’re usually at the top. Even with the biggest oil bear market in decades, last year ExxonMobil generated cash from operations of about $30 billion. Tesla’s entire market cap is about $60 billion. And they had negative cash flow from operations.
When oil prices were north of $100, ExxonMobil was generating close to $60 billion a year in cash from its operations. So, the supermajors have the financial strength to take part in a changing energy landscape.
In fact, we’re already seeing this. They are making a big shift and investing back into the downstream part of their business. Things like refining, processing plants, and petrochemical operations.
Part of it is to help buffer profits when the exploration side takes a hit, like it did when oil prices collapsed. Part of it is to position themselves for a world with less reliance on fossil fuels. Petrochemical production is projected to be the major driver of oil demand growth over the next several decades.
Another area downstream they are investing in again is gas stations. This will create opportunities to participate in the EV shift, as the investment in gas stations will give them the footprint to offer electric-charging stations.
Just last year, Shell bought one of Europe’s largest electric-charging businesses. It even got together with car manufacturers with plans to install hundreds of charging stations at existing Shell outlets around Europe over the next two years.
It’s likely we'll see more deals and investments like this going forward.
L: Big Oil becomes Big Energy—makes perfect sense. That and all these energy trends will be worth watching closely. Thanks for your time and insights, Chad.
