August 13, 2021
What happens when the most powerful force in the universe collides with the most important source of energy on Earth?
In the coming years, we’re going to find out – when mean reversion smashes into oil demand. And who will win?
Hint: Not you, when you’re filling up your gas tank… or your ExxonMobil shares… or that clean-energy ETF you bought that’s up by triple digits over the past two years.
In an example of the law of unintended consequences, the evolving dynamics of oil supply and demand won’t benefit who or what you might think. And it might actually help some countries that appear to be most likely to suffer.
As I’ll explain, you – and your brokerage account – can still come out ahead in this conflict….
The Most Powerful Force
Mean reversion is when things go back to the mean (that is, the average). In a coin toss, after five heads in a row, the chances that the next flip of the coin will be heads is 50%… the same as with any coin flip. But the chances of six heads in a row are just 1.6%.
A string of good luck – say, six three-pointers in a row in a basketball game – will eventually end. So, too, will a run of bad luck. Periods of great joy – or extreme grief – eventually even out, to the dull beige that’s normal life… That’s mean reversion. It’s the pendulum swinging back.
When applied to investing, mean reversion refers to extreme price movements eventually correcting – and reverting to the mean, like a rubber band. If the share price of your boring and old power-utility stock moves up 30% in a month, chances are (all else equal) that hot sentiment is going to cool off. After that, you’ll be in for a period of subsequent underperformance.
Similarly, it’s a question of time before the streaking tech stock that’s setting Twitter aflame and going hyperbolic will cool off – or collapse. Nothing goes up forever… thanks to mean reversion.
And right now, the attitude toward the future of oil is about as bad as it gets. And it’s time for a readjustment – to the mean.
The End of Oil – Right?
It seems climate change is killing the oil industry…
As I wrote in May, the Paris Agreement climate change treaty calls on participating countries – pretty much everyone, including (as of February) the U.S. (again) – to reduce the emission of greenhouse gases into the atmosphere. The accord’s aim is to limit the rise in global temperatures to 1.5 degrees Celsius (3.6 degrees Fahrenheit) above pre-industrial levels.
And since fossil fuels (including, most prominently, oil) account for 89% of greenhouse gases, oil is in the crosshairs. A 2015 study found that around one-third of the world’s oil reserves – as well as half of total gas reserves, and upward of 80% of coal reserves – will need to not be produced at all, and instead left in the tight grasp of Mother Earth… in order to prevent further global warming.
More recently in May, the International Energy Agency (“IEA”) called for the oil and gas industry to end efforts to find new reserves, so that the world can achieve net-zero carbon dioxide emissions by 2050 (a requirement for the Paris accord to hit its goal). Along the same lines, a centerpiece of the Green New Deal of the liberal arm of the Democratic party in the U.S. is to sharply reduce fossil fuel emissions to achieve net zero emissions.
What this means is that there are plenty of grave diggers for the oil industry. Environmentalist organization Sierra Club proclaimed in April last year that the “end of oil is near,” explaining that “the pandemic may send the petroleum industry to the grave.”
During a presidential debate in late October, then-Democratic presidential candidate Joe Biden said that his administration “would transition away from the oil industry.” The International Monetary Fund opined this summer that recent strength in the price of oil – it’s nearly doubled since late-October – “could be the last super cycle for oil” before the “end of oil.”
The case of the end-of-oil-ers is bolstered by big western oil companies committing hara-kiri. Under pressure from governments, investors, and environmentalists, the oil majors – the Big Oil club of publicly traded global producers ExxonMobil, Chevron, BP, Royal Dutch Shell, TotalEnergies in France, and Italy’s ENI – is facing the prospect of stranding – writing down, abandoning, leaving for dead – around $1 trillion in fossil fuel assets in coming years.
One estimate suggests that around a further $140 billion in oil and gas assets are up for sale. That follows the sale of $28 billion in assets over the past three years by a handful of major global oil producers.
Investors are reading the room… The share price of the iShares Global Energy Fund (IXC), an ETF that holds a who’s-who of big energy companies, is down about 20% over the past five years. (During that time, the S&P 500 Index has more than doubled.)
The worst thing you can do is to sit idly by and do nothing. Find out exactly what’s going on in America, why this grocery store billionaire is so concerned about this coming October, and four steps every American should take right now, right here.
Time for Oil Sentiment Mean Reversion
Given all that, you’d be forgiven for thinking that oil no longer matters… that it’s headed to the “where are they now?” list of once-great corporate titans that are relegated to the minor leagues of the midcap index.
But not so fast… Oil accounts for around one-third of energy consumption globally. That’s more than coal (27%) and gas (24%). And it’s more than three times as much as hydropower, wind, and solar combined (9.7%).
The engine of the global economy, China, is oiled by… oil, which accounts for 19% of total energy consumption – up by 15% over the past decade. (Coal, a far worse polluter than even oil, is responsible for 58% of China’s energy production… but that’s another story altogether.)
And who gets the call if the global economy needs more energy? Not the sun or the wind… but the oil guys.
“White House calls on OPEC [oil cartel Organization of the Petroleum Exporting Countries] to boost production to contain fuel prices,” blared a headline in the Financial Times on Wednesday.
That’s the Biden White House – calling for more oil production, to keep down pump prices during the summer driving season. Never mind that gas in the U.S. costs less than almost anywhere else in the developed world. In the U.K. and much of Europe, for example, filling up your tank costs around twice as much… what Americans might have to look forward to if oil goes the way of the lead pencil.
(A brief primer on oil, presented under the cover of “things you think you should know, but don’t, and feel like it’s too late to ask even Mr. Google without feeling like a total ignoramus”: Only a relatively small amount of crude oil, which is the stuff that comes out of the ground, is used in that raw form. Most of it is refined into petroleum products, like gasoline – that’s why we’re always talking about the price of oil in relation to the price at the pump – as well as heating oil, jet fuel, and diesel.)
Maybe most tellingly of all, in October last year, the IEA projected that global oil demand will plateau in coming years – but begin to decline only in 2040. That’s two more decades of steady oil demand. And it’s a plaid-with-polka-dots contrast to the hyperbolic calls for the imminent demise of the oil industry.
What does it all mean? The pendulum is swinging back for oil… from “the death of oil” to “hang on, not so fast.” Sentiment is reverting to the mean. That’s good for oil company profits and share prices in the short term (oil company ETF IXC is up 63% since October).
What’s Next for Oil
But looking out past the next few years – and the modest reversal of the negative sentiment toward oil – what’s going to happen?
Pressure from the New Green Deal-ers and the Paris Agreement folks – as well as from everyone else who doesn’t want a world where their grandchildren will need fins to survive if they live within 60 miles of a coast – suggests that Big Oil will be sacrificed at the altar of net zero.
The big publicly listed energy majors that are taking all of this in on the kisser – though they’re the oil companies that we talk the most about – aren’t all that big. All together, they account, according to the IEA, for just 12% of oil and gas reserves, and 15% of production.
In contrast, national oil companies, which are mostly or completely owned by governments – like Saudi Arabia’s Aramco, the United Arab Emirates Abu Dhabi National Oil Company, Russia’s Rosneft, Qatar Petroleum, and many others – account for more than half of oil production, and far more in terms of reserves.
And not all oil companies, or countries, take climate change quite as seriously as the anchors of the Paris Agreement, or the oil majors that they can strong arm. And for some countries, cutting fossil fuel production would be an extinction event for their governments, if not for their economies.
According to emerging and frontier market broker Tellimer, fuel exports (depending on the price of oil) account for around 30% of Iraq’s GDP… 23% of Saudi Arabia’s… 11% of Russia’s total economic output… and 26% of the GDP of Qatar.
For them, the stranding and offloading of assets by the western oil majors is a once-in-never opportunity to gather assets and expand market share… and to anticipate a far higher oil price in the future.
As the Financial Times explained in July…
The pressure on the majors to divest assets has led some energy executives to argue that the focus on listed oil and gas companies by environmentalists and investors is misguided…
Some energy analysts believe that the transfer of projects away from the oil majors does little for the environment and in fact may only boost emissions as production likely shifts to players that operate in the shadows, answer to private shareholders and make few environmental disclosures…
As potential buyers of last resort, many producer countries [such as Saudi Arabia] only see the majors’ shift away from oil and gas as an opportunity to grow their own market share.
In short, clean energy and anti-/post-oil will experience a sharp mean reversion, as investors anticipating the death of oil get ahead of themselves. Oil, including Big Oil as we know it in the West, is going to be around for a lot longer – and be a lot more difficult to get rid of – than the net zero folks would like.
But once Chevron and BP and the rest of the gang have stranded or sold much of their fossil fuel assets, the main oil game in town will be the national oil companies. As oil production falls – if it does – over the next 20 years, the share of oil produced by national oil companies in petrostates will rise. Then, if you want oil, you’ll have to knock on the doors of Russia, Saudi Arabia, and OPEC – which may someday pay a steep price for not more effectively diversifying their economies away from energy… But thanks to “death to oil,” that time might be a lot longer than most people imagine.
The “oil majors” of the West will fall into the shade of Rosneft (controlled by the Russian government, with a public float and shares that are traded in New York and Moscow)… Aramco, which is listed on the Saudi Stock Exchange… Gazprom, the world’s biggest publicly traded gas company (with shares also traded in New York)… and others.
Don’t put them on your buy list just yet, but they’ll be the survivors, as mean reversion unfolds – again.
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August 13, 2021