I’ve just finished reading a wonderfully detailed and entirely convincing position paper by Swiss fund manager Burggraben. I can’t say I know the firm but on the basis of the paper on the energy markets I’ve just read, I’d say this is one to follow closely. The report on Crude Oil is provocatively entitled “are you ready for triple digit oil prices” and it came out towards the end of last month.

It starts by quoting Myron Watkins from the 1930s who once famously declared that problem with oil “is that there is always too much or too little”. And this really is the crux of the paper – the price of oil really does hinge on a unique combination of short term and long term factors, any of which could push the price of oil markedly higher (or lower). In sum, what happens at the margins, makes a huge difference.

The first key point is I think the most powerful one – that although the US unconventional shale story is important, it can’t really make that much difference to global prices. According to the report the although output from, say, the Permian in Texas will increase markedly the  “incremental price responsive volume is likely less than 0.5% of global consumption and the remaining supply is far from stable due to the inherent reservoir or geopolitical instability. It is structurally irrelevant for a 100 Mb/d market once it suffers from a (supply gap and/or disruption) deficit”. The point is that shale’s shorter cycle ebb and flow” can stabilize prices, but only coincidentally and depending on prevailing, broader – structural – market fundamentals.”  If Shale is really going to make a global difference and push down prices markedly we’d need to see output growth of 33% year over year growth for the Permian, the core US shale basin. “Now that is impressive for an asset class that needs to replace 35% of its annual production with new wells every year just to stay still. It is even more impressive for an industry where the best wells produce less than 500 barrels of crude a day (not including gas & NGL) in the first year and less than 200 barrels in the second. For perspective, we estimate that our growth will consume at least US$ 85 billion of capital just to drill the wells and only in 2018. A capital intensive business model indeed and one that did not deliver returns above their capital cost to shareholders for more than a decade now, we might add!”.

Sticking with the supply side of the equation, the authors also point out that although shale may have an impact at the margins – by increasing supplies – other geographies could have a counter vailing impact, thus decreasing supplies and reducing inventories.  Venezuela is the most likely source of disruption.

“It holds the world’s largest oil reserves but its daily production has shrunk by 50% in the last ten years, from 3.3 Mb/d down to currently 1.7 Mb/d as a result of a failing government. Further production declines down to 1.4 Mb/d seem inevitable as workers grow too weak and hungry for heavy labor.”

If producers such as Venezuela are hit, we could see a dangerous decline in spare capacity.

“We argue that the producible spare capacity within weeks is closer to 2.0 Mb/d as Venezuela, Iran, and Iraq need maintenance of their capacity reserves. That compares with more than 3.0 Mb/d of oil supply at risk of geopolitical disruption at any one moment. So, the structural supply of a 100 Mb/d market cannot be dampened by US shale’s variable supply response from higher prices within one year of, say, 0.5 Mb/d nor can the Saudis significantly alter the trend of higher prices by applying their 2 Mb/d of spare capacity”.

So short term disruptions can make a huge difference, especially when even the Saudi’s are struggling to hold the line as a key structural swing producer. “The industrialization of China, which led to global oil consumption outgrowing new discoveries ever since, [has] resulted in a structural inability of any one country to invest in sizeable spare capacity in order to prevent prices from spiking” following supply outages and geopolitical risks.”

One last factor to consider – the low prices of the last few years has also caused a structural decline in investment in new capacity. Over the next few years this shortfall in new mega fields for instance could have a major impact at the margins.

“Certainly, by 2020 the world economy will need but lack new oil production from long-cycle projects that were cancelled or delayed since the 2014 bust. We thus contend that the risk of supply constraints will resurface long before the risk of global demand peaking, and a steady tightening in the supply/demand balance post-2017 is behind our view that oil prices could spike as soon as 2019 as prices need to incentivise the exploration & development of new, conventional barrels around the globe – once again, barring a world recession in between!”

Turning to the demand side, we’re seeing a steady but perceptible increase in demand from a strengthening world economy.

“Q4 2017 was probably the first time in at least a decade when almost every region in the world was exhibiting strong economic momentum, and oil demand followed. A world economy growing at 4 per cent as the IMF projects will require nearly 2 Mb/d of net supply growth per annum. This really means adding 4-5 Mb/d of new gross supply once declines from existing fields are considered”.

The bottom line ? Within the next 24 months and barring an economic recession, Burggraben expects oil prices to increase significantly…
– as the OPEC/Non-OPEC alliance will continue tightening the supply side well into 2019 to buffer current shale growth, thus creating inventory draws throughout 2018;
– as prices will react more volatile to supply disruptions as surplus inventories are eliminated and amid wafer-thin spare capacity;
– as above-consensus demand growth will compensate for Texan oilmen’s drilling frenzy;
– as the legacy project pipeline outside North American dries up, leaving a widening supply gap for the near term outlook;
– as higher decline rates of maturing fields will kick-in as a result of years of industry underinvestment;
– as cost inflation returns because the industry steadily increases capacity utilisation, thus pushing the marginal supply cost curve higher; and
– as mid-term shale growth will disappoint from a combination of more sober drilling results, take-away capacity issues as well as labour constraints.

The table below rounds up the aggregate estimates for oil prices with the mean forecast solidly in the $50 to $70 price range – which is probably where I’d estimate that prices might stay.

Burggraben by contrasts reckons these numbers could be way off the mark. They reckon that OPEC spare capacity could be down to zero by 2020, with demand in that year running at 102 million barrels a day compared to 98m currently. This, they argue, could put oil prices in the 3rd quarter of 2019 above $100 for Brent.

I’m not completely convinced by these arguments – I think it underestimates downside risks for the global economy and also downplays the ability of US Shale and the Saudi’s to ramp up output. My sense is that the Saudi’s would also be worried that oil prices in triple figures would be a recipe for inflationary disaster – inviting an economic meltdown and a tumbling price for their biggest export. So, my hunch is that they’ll move heaven and earth to keep prices well below $100. But the analysis presented here is convincing.

Its wider portfolio implications are huge. It raises the real prospect of a big inflationary shock which would be calamitous for most bond markets, implying sharply higher interest rates. It would also suggest that any ESG portfolios that avoided energy stocks would be huge (relative) losers. Lastly, it might support a huge bull market in energy stocks, and a boost for renewables.