The Hazards Of Investing In Oil: Part 3

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The 2022 Offshore Technology Conference is underway in Houston. This annual gathering highlights that the fact that 88 percent of oil in the world market is produced outside the U.S. but with U.S. technology. Because the U.S. consumes more than it produces, we are at once a major buyer of oil and refined products on the global market, as well as a major producer. Global market turmoil hits us both ways, and the knee-jerk reactions from Congress and the White House are to raise costs for the domestic industry, discourage new domestic investment, and search for more supply from Iran and Venezuela—both sworn adversaries that are reeling from our effective sanctions that have damaged their oil production. Nevertheless, our leadership has one thing right, we are in it together, whether we like it or not. Is $100 oil worthy of your investment dollars?

John Nash, the Nobel winning economist for his work on game theory described how the action of a producer impacts a market and drives the subsequent actions of other producers in that market. No market demonstrates this as well as the global oil market. Nobel winning economist William Nordhaus pointed out that oil prices around the world move in lockstep no matter the grade, quality, interruptions or changing conditions. If there is a supply disruption in Europe because of the war, the price at the pump in Houston is affected. Under Nash’s theorem, producers will observe each other’s behavior and be smart enough to coalesce or converge to make higher profits. Nash assumes no explicit cooperation to arrive at this conclusion.

Even though prices move in lockstep, the game board is not symmetric for producers nor for consumers. Internal rules and regulations govern how they play. U.S. producers are forbidden from colluding. EU producers are required to pursue low-carbon agendas. OPEC and Russia have rotating agendas that include weaponizing the supply of oil. Some consuming nations have alternatives to oil, but many do not.

OPEC has been a thorn in the side of global oil companies and producers since 1960. It explicitly colludes to raise or lower production to raise or lower the global price of crude oil. While the market share for OPEC has declined over time, they are still the “swing” producers in the market because they have the freedom to dial up or dial back production and still make money on their oil. The U.S. producers are the highest cost producers in the global markets, requiring $30 per barrel oil to break even on the best shale wells and sustained prices of more than $75 per barrel to justify new deepwater offshore wells.

With this freedom, it was easy to see in 2013 that OPEC would institute a price war to drive down oil prices below the breakevens for the U.S. shale plays. The war started in December of 2014. The U.S. oil industry lost more than 100,000 jobs, hundreds of billions of dollars in market capital, and additional billions in state, federal and local tax collections. Consumers reveled in the low fuel prices and gave no thought to the hundreds of bankruptcies in the oilpatch.

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Pundits point out that OPEC lost money on the price war and eventually capitulated. But did they? Or did OPEC begin the price war after their national oil companies and sovereign wealth funds had made trades that would allow them to profit from lower oil prices? Such behavior is illegal in the U.S. but not in Russia or OPEC countries.

Not all OPEC nations can act this way. But it is easy to see that Nash’s non cooperative game is alive and well beneath the façade of seeming unity as members double deal each other. As for Russia, the Soviet Union bought cheap grain and futures in Chicago in 1972 in anticipation of their own crop failures. In the midst of the Cold War, the Soviets had embraced a tool of capitalism.

For the investor looking just at the numbers, the futures prices today on NYMEX for oil 18 to 24 months out fall below $80 per barrel. Buying into a private deal, or even a public company, at a high price today would seem to guarantee disappointing results for the next 18 to 24 months. The downside scenarios that peace breaks out or the pandemic intensifies will restrain capital. There is no obvious hedge. And for the investor whose hands are tied by U.S. law, success may depend more on Putin and Saudi Arabia’s Mohammed bin Salman than first thought. They like the high prices for now. Is that a smart play?

In Part 4, we will review some of the tactics employed by oil companies among oil companies, or wannabe oil companies.