On Friday, the International Energy Agency (IEA) released their latest monthly Oil Market Report. There will be lots of detailed analysis of the report available to investors, and market specialists will parse every number and opinion therein. The highlights of the report include the observations that unusually high US refinery crude runs are coming to an end and that OPEC is cutting supply, falling below 30 million barrels per day (mmb/d) for the first time in around 2 years.
This has been generally, and probably rightly, interpreted as bullish for crude prices in the short term. For the average investor, however, the long-term trends and dynamics of pricing are more important than daily or even quarterly fluctuations. For obvious reasons, any serious spike in oil prices can do significant damage to corporate profits, and therefore stock prices. Similarly, an orderly drop in prices can impact the profitability of oil companies, but otherwise help economic growth.
The long-term pressure on oil prices is well documented but is worth repeating. You don’t have to be an economic genius to understand that there are two fundamental factors affecting the price of a commodity: supply and demand. In oil’s case, both factors are influenced in a way detrimental to pricing.
From the supply side, while the overall quantity of fossil fuels is finite by nature and a large part of production can be controlled by cartel, supply continues to increase.
The US Energy Information Agency chart above doesn’t look spectacular, but both the three year and thirty year trends are fairly obvious.
This increase in supply is almost inevitable. The technology of extraction continues to improve in both “fracking” to extract oil from shale fields and deep water drilling to access previously unexploitable resources. The controversy surrounding both techniques is undeniable, but nor is the fact that both are being used to increase production. As I mentioned, supply is controlled by cartels such as OPEC and, to some extent, the oil companies themselves in the short term, but continues to increase.
This increase in supply is counterbalanced by increasing demand. As emerging market economies continue to grow, so does their demand for oil. The report cited above shows non OECD countries combined demand for oil increasing from 41.4 mmb/d in 2010 to 45.2 mmb/d in 2013, an increase of close to 10% in three years. The rate of economic growth in emerging economies is slowing, but they are still growing, and so is their thirst for oil.
Where the demand side of the equation is likely to change, however, is in the developed world, at least at first. From a US perspective it can be hard to appreciate the level of commitment to energy from sources other than fossil fuels that exists in the rest of the world. The issue of alternative energy sources has become deeply politicized here, with a vocal minority denying even the existence of climate change.
The fact is that the US economy is, to a large extent, influenced by the fortunes of the oil industry, and there is a quiet consensus that it must remain strong. That consensus doesn’t exist in most of the developed world. Elsewhere, energy policy is not a left vs right issue. Angela Merkel, the recently re-elected German Chancellor, for example, is from a center right political party, yet embraces an energy policy that looks to end the country’s dependence on nuclear energy and fossil fuels. Such a plan from the political right is unthinkable here in the US.
Emerging market demand will continue to grow for a while, but as non-US developed countries begin to throw their weight behind research into alternative energy sources, it is likely that the cost of these methods will decrease and they will become more attractive to those emerging nations.
This will not happen in the next year, or even the next two or three, but the knowledge that it will happen one day puts a cap on oil prices, even when there is a possibility of supply disruptions. The trouble in Syria saw crude prices jump to around $110 per barrel, but the drop back is underway.
The $80-110 range that oil has been in for the last few years is quite wide, but given the long term dynamics, looks to be set for a while.
In this environment, it is hard to get enthusiastic about the prospects of big oil companies’ stock. Most of the benefits of fracking oil and natural gas are going to smaller exploration companies, as I talked about here, and the major companies are likely to see demand squeezed in the coming years.
Exxon Mobil (XOM), BP (ADR:BP), Chevron Corp (CVX) and Conoco Phillips (COP) each have their own dynamics, but in the context of a good year for stocks, only COP has been even average.
The short term outlook, as outlined in Friday’s report, may be somewhat bullish for oil prices, and therefore for oil stocks, but it is hard to get excited about the companies’ prospects when you take a step back. As the commodity they produce comes under increasing pressure, the prospects for significant earnings growth look slim and the stocks look likely to remain stuck in a rut.