onurdongel
Co-authored with Philip Mause.
This is a follow-up article discussing the macroeconomic forces at play in energy that have influenced our stock selection in the sector. There has been a shift for the U.S. from being a net consumer of energy to a net producer. This means opportunities for income investors like us! Part 1 of the series laid out an overview, and Part 2 covered Natural Gas. Today’s report focuses on Oil (CL1:COM), and the final article of the series will cover Renewables.
The Massive Increase In U.S. Energy Production And Its Consequences For Investors (Part 3) – Oil
In the period of time covered by this series of articles (2007-2023), the United States has gone from being the world’s largest oil importer to becoming the world’s largest oil producer. Despite the pretensions of a “national energy policy,” this change was not primarily the product of a public policy initiative. Instead, it is due to technological innovation, hard work, and entrepreneurship by the private sector and a degree of reticence by policymakers (“government staying out of the way”). It is a major change that has not been covered thoroughly enough by the media and may not be fully appreciated by economic analysts.
Some Reference Points – Oil and oil products are generally measured in barrels or gallons (42 to a barrel). Oil and oil products generally produce roughly 6 million BTUs to a barrel, although this varies somewhat. Oil is often divided into categories based on weight (heavy or light) and sulfur content (sweet or sour). Almost all oil is consumed in the form of refined products – including gasoline, middle distillates (heating oil and diesel fuel), residual oil, kerosene, and other products.
Oil has some very significant advantages over other hydrocarbons. It has high energy density, which gives it an advantage as a transportation fuel (it is hard to imagine a coal-fired airplane). It is relatively easy to transport and store at normal temperatures. Its discovery and introduction into the market was extremely disruptive to competing materials – first, to whale oil, then to wood and coal, and later to animal feed.
There has probably been more written about oil than all the other energy sources. For a long time, there was a theory of “peak oil” based on the notion that there was a finite amount of oil in the ground and that there would come a point at which production in the United States and then in the world would necessarily decline.
There have been technologies to produce synthetic oil, but they have almost always been prohibitively expensive. Oil is distributed very unevenly around the world, giving rise to major oil exporters and importers and a complex trading system. More than other energy sources, oil has been viewed as a matter of national security with a Strategic Petroleum Reserve. World War 2 was, in part, fought over oil and oil boycotts, and sanctions have been used to exert political and military pressure frequently.
A Little History – Oil was “discovered” as a commercial product in the 19th century and very quickly displaced whale oil in its use for lamps. Sag Harbor and New Bedford – the key whaling hubs – went into rapid decline. If Herman Melville had been born 50 years later, he would never have written Moby Dick.
It gradually displaced coal as a marine fuel – notably due in part to Churchill’s decision to switch the Royal Navy to oil shortly before World War 1. The automobile and the airplane would either have been impossible or turned out very differently without oil products. It is speculated that one cause of the Great Depression was the rapid deployment of cars and trucks, which eliminated the need for horses and enabled roughly one-third of U.S. farmland to be repurposed from producing animal feed to producing human food, thereby creating surpluses and a collapse in prices.
In the early days, the United States was a dominant oil producer, and there were times when a large percentage of world oil output came from Southern California. There were periodically massive discoveries leading to price instability, and for a time, the Texas Railroad Commission played a key role in regulating prices by limiting production.
U.S. demand for oil exploded partly due to the postwar explosion of automobile and truck transportation as well as the replacement of coal by oil as an electric generating fuel. The U.S. demand for oil began to exceed domestic supply, and imports increased. A theory of “peak oil” was proposed by M. King Hubbert (not an actual “king”), and U.S. production began to decline in the early 1970’s. Due to the Yom Kippur War in 1973 and its aftermath, Arab oil-producing states implemented a boycott, and prices exploded on the upside. This led to a very dysfunctional system of oil price regulation, a U.S. focus on “energy independence,” the creation of the Department of Energy, and the declaration of the “moral equivalent of war” by President Carter. After all of this activity, we faced another oil price explosion in 1979 due to the overthrow of the Shah of Iran.
We then had a surge in international production, a deep recession, and the abandonment of domestic oil price regulation and allocation, followed by a very long period of relative price stability and even decline. The 1990 trouble in the Gulf led to a price bump, and then prices declined with the fall of the USSR. Prices started to move up again, heading into the Panic of 2008. As we came out of that recession, U.S. production started to surge and continued that increase going forward.
The table below provides U.S. production, consumption, and net imports by year in millions of barrels per day for crude oil and natural gas liquids. The data generally supports the above narrative.
| Crude oil prod. | NGL prod. | Net imports | |
|---|---|---|---|
| 1950 | 5407 | 499 | 545 |
| 1960 | 7034 | 929 | 1613 |
| 1970 | 9408 | 1660 | 3161 |
| 1980 | 6908 | 1573 | 6385 |
| 1990 | 5582 | 1559 | 7161 |
| 2000 | 4851 | 1911 | 10419 |
| 2007 | 4352 | 1783 | 12036 |
| 2022 | 11911 | 5933 | -1191 |
What Has Just Happened?
The table above shows a striking increase in production, pushing output above the “peak” levels seen in the early 1970’s. This sudden change is largely due to the emergence of a method of accessing and producing hydrocarbons from previously inaccessible sources. The change created skepticism about “peak oil,” although the debate continues. It is best analyzed as a constantly changing tradeoff between the exhaustion of easily lifted oil reserves and the improvement in exploration and development technology.
Starting around 2006-09, a new technology for oil production emerged. Although fracking has occurred for a considerable time, innovations led to a much more productive form of hydraulic fracking, which opened up production in shale oil regions. This increase in production was an important factor in helping the U.S. recover from the 2008-09 recession. It also pushed our production up to the point that we are arguably a net exporter and – in any case – much less dependent on imports than in the past.
In this connection, it should be noted that there are two ways calculations are generally made – based on crude oil and refined products, and based on all liquid fossil fuel products. The latter calculation includes the large volume of “natural gas liquids” produced when natural gas is produced. Using the broader definition, the U.S. is now a net exporter; using the former definition, we are still a small net importer.
The U.S. is still not fully “independent” with respect to oil. We still depend on crude oil imports to a significant degree. Many of our refineries require relatively “heavy” oil, and we do not produce enough of this type of oil domestically to supply those refineries. Thus, we simultaneously export light oil and import heavy oil. We also are net exporters of refined products.
The table below provides 2022 numbers which set forth this situation in millions of barrels per day.
| 2022 | Crude Prod | NGL Prod | Proc. Gain | Crude Imports | Other Imports | Crude Exports | Other Exports |
|---|---|---|---|---|---|---|---|
| 11,911 | 5,933 | 1,032 | 6,081 | 1,038 | 3,576 | 5,942 |
The Future – Because it is relatively easy to transport oil, prices in the United States are largely determined by the world oil market. We attempted to maintain U.S. prices below the world level in the 1970s with a bewilderingly complex oil price and allocation regulation system that had many negative consequences. There does not appear to be much appetite for a return to that regime. Thus, U.S. prices are very likely to be determined by the state of the world oil market.
We live in a world with many large exporters and large net importers, and international oil trade is both economically and strategically of vital importance. In recent years, it is fair to say that production has generally been below the physical capacity level due to various political constraints. These include sanctions, boycotts, disruptive revolts, and other factors that have led production in Iran, Iraq, Venezuela, Russia, and some of the African-producing countries to be substantially below the levels that could physically be produced. For example, the recent imposition of sanctions on Russia roiled the international market in early 2022, but the market gradually settled down as Russian oil found new but less profitable markets and freed up other European and East Asian importers by displacement. The overhang of potential production that is “shut in” for political reasons may suggest the potential for excess supply if political constraints are relaxed.
There is a perception that, in the very long run, pressure to reduce fossil fuel consumption will reduce global demand for oil, but there is a great deal of disagreement about how long this will take or even whether it will ever occur. The reality is that alternate sources of energy have problems of their own and that, at least in the short term, their contribution to the energy puzzle may be overwhelmed by increasing fossil fuel demand from developing countries.
In the short term, it is very difficult to project prices, demand and supply, and there can be wild fluctuations in price. In the intermediate (10-15 year) term and the long term, there is also considerable disagreement in terms of where we are heading.
One possible scenario is that a combination of unrealistic optimism about renewable energy and hostility to fossil fuel production will lead to pressure on the oil industry to reduce development efforts and produce a shortage and rapidly rising prices. This, of course, could produce a “backlash,” leading to a public policy regime that is more friendly to fossil fuel development and production. The history of the oil industry has often featured cycles of “feast and famine,” with a period of high prices leading to overproduction and, thus, an ensuing period of low prices and excess supply. It is not unlikely that we may face this going forward.
Long-term projections of global oil production vary considerably – OPEC projects that we will use 116.1 (with a range of 98.0-122.4) barrels per day in 2045 (the 2023 number will probably be 101.9); the U.S. Department of Energy projects 116.7 (with a range of 110.4-120.11) for that year; and the International Energy Agency has a projection of 54.8 for 2050 which it describes as “stated policies” – presumably assuming that various countries perform consistently with their stated policies.
These numbers suggest a moderate increase together with considerable uncertainty. This, in turn, suggests that we may see “surprises” in either direction as we proceed. These could be caused by surprisingly high demand or a disruption in supply.
Investment Implications – The continued growth of oil production in the United States is definitely bullish for the dollar because it means that the United States is better positioned to weather the storm of an oil supply disruption than other countries with currencies that are potential successors to the dollar as the global reserve currency (the Euro, the British pound or the Yuan). It also may reinforce the role of the dollar as the currency used for pricing international oil transactions. All of this suggests that investors focus on U.S. investments.
The U.S. energy sector will probably continue to perform reasonably well and, of course, could outperform if there were to be another energy price explosion created by international tension, supply disruption, or simply a shortfall in supply created by underinvestment. In that sense, an overweight position in the oil sector could function as a kind of “hedge” against developments that might have negative effects on the overall market.
Some attractive opportunities in the sector are Enterprise Products Partners (EPD), a midstream company with extensive pipeline and other energy infrastructure assets, which now yields 7.5%; Antero Midstream (AM), a very successful natural gas-oriented midstream pipeline company which now yields 6.9%; and BlackRock Energy and Resources Trust (BGR), a closed-end fund which primarily owns equity in the major oil companies but also holds shares in other major petroleum oriented entities.
BGR is a great way to diversify in the sector as it holds some of the biggest names, including Exxon Mobil (XOM), Chevron (CVX), ConocoPhillips (COP), Shell plc (SHEL), and TotalEnergies SE (TTE), amongst others. BGR now yields 6.2% and trades at an attractive 12% discount to net asset value.
