Energy stocks jumped after the November US election because investors thought new management in Washington would be their ticket to higher pricing. But lets take a look at things from a more detailed perspective?
On the surface, with President Trump promising to reduce the Oil and Gas industry’s regulatory burden and open more federal land and offshore areas to drilling it was clear things would get better. Furthermore, lower taxes and friendlier regulation will supposedly boost US domestic economic growth—and increase energy demand with it.
Maybe it will all work that way, lets see
ON the positive, higher pricing for energy side, we know that energy production is a highly regulated industry, and Trump will make it less so. The president demonstrated this last week when he revived the Keystone and Dakota Access pipeline projects, which had been stalled by his predecessor.
Also, Trump’s key appointees should be a boon for the industry:
Reducing compliance headaches will make life much easier for oil and gas companies. As the economists love to say “All things being equal”, this should translate into higher profits.
There’s just one problem: All other things aren’t equal.
The challenge of Supply & Demand
We all know the supply and demand curve from Economics 101. However, in most cases (all things being equal) the seller’s cost to acquire the goods isn’t part of this equation. It is an indirect factor. For example Lower supply costs let sellers supply more, thereby pushing the unit price lower.
Here’s the lowering costs of production of US Shale oil
IN addition there are also increasingly unconventional sources of oil, and as these become more affordable, supply will increase, causing a capping of prices.
This is the oil industry’s present problem. The very same factors that reduce their costs will also lead to higher supply. In the absence of higher demand, lower prices will follow.
So what about that demand growth? Will we use more energy in the coming years?
Yes, says the new BP Energy Outlook, an exhaustive report from the former British Petroleum. BP thinks world energy consumption will grow 1.3% per year from 2015 to 2035. That’s impressive until you consider that it grew 2.2% a year from 1995 to 2015.
Why the low estimate on energy growth? In recent years, the amount of energy it takes to generate economic growth, or “energy intensity,” is shrinking fast. Today’s vehicles and technology are far more fuel-efficient than those of the past. BP believes world GDP can double in the next 20 years with energy usage growing only 30%.
Worse, the demand growth isn’t happening here. It will be flat or even decline in the OECD countries (the US and other developed markets), with most growth happening in China, India, the rest of Asia, and Africa. (see graph below the next graph)
The energy mix is changing too. Renewable sources like solar are growing fast in much of the world. Depending on location, in many places solar is now economically on par with fossil fuels, even without government subsidies. And these technologies will only improve.
So if demand for oil, gas, and coal is flat or rising slowly, producing more of these energy sources will keep prices steady at best, and more likely push them lower. Here’s the variable costs for producing various energies from Lazard in December 2016
There’s likely to be a supply glut f energy in the future, if things keep going they way they are. The left chart below, again from the BP report, shows global proved oil reserves growing steadily since 1980.
Now, in reality the oil supply is not growing at all. Whatever is down there is what we have. So when we say supply is rising, we mean we’re finding more thanks to improved technology.
The right chart above ought to terrify those who hope for energy pricing to increase. Even if the entire world stopped exploring for oil right now, the amount we’ve already located is more than twice the cumulative projected demand from 2015 to 2050.
So if you own some of those untapped reserves, this tells you to bring your oil to the surface as fast as you possibly can. Sell it to someone while they still have a use for it. Otherwise, you’ll be stuck with oil that nobody could want as alternatives to oil increase and their pricing reduces.
That’s what is happening too, despite the oil price falling sharply since 2014.
Debt-financed energy producers keep producing even when the oil price is below their production cost, just to cover their debt service. They literally can’t afford to stop—and that’s capping the oil price in the $50–$60 range. Lower production costs mean the supply curve can shift even more, letting producers supply the same quantity at a lower price. If that happens in a declining-demand environment, the price can drop even lower—and almost certainly will.
Similar trends are underway in coal and natural gas. All these energy sources face abundant supply, falling production costs, and lower demand.
In the aggregate, the extractive energy sector faces serious headwinds, and there’s nothing President Trump and/or the US Congress can do to change it.
So if you’re looking forward to forecast energy costs, don’t assume costs will rise, and increase supply, reduced costs to supply and plentiful alternates cold mean lower energy pricing in future.