Long term oil prices beginning to reflect the coming oil shortage – Part I

[Ptarmigan]

Long term oil prices beginning to reflect the coming oil shortage – Part I
https://www.goldmoney.com/research/goldmoney-insights/long-term-oil-prices-beginning-to-reflect-the-coming-oil-shortage-part-i

Brent crude oil prices rallied $100/bbl since the lows in 2020. This reflects very tight fundamentals, where petroleum inventories are at extremely low levels relative to consumption and supply is struggling. The war in the Ukraine has worsened the near-term supply outlook further. The current conditions in the oil market are critical and we could see real oil shortages by this summer if the disruptions to Russian oil supplies persist or even worsen. This would put even more upward pressure on current prices and overall inflation. However, we think an even bigger and more permanent issue has been brewing in oil markets for years and it is finally filtering through to the back end of the forward curve. Longer dated prices have broken out of their 5-year range and have been moving up relentlessly. We think the oil markets finally begin to understand that a lack of investments in large oil projects over the past years is threatening supply over the entire next decade, at a time when demand will still be growing as the electrification of the transportation sector will not impact demand meaningfully for years to come. The sharp upward moves in oil prices amidst a broader commodity prices rally have pushed realized inflation and near-term (0-2y) inflation expectations up strongly. But inflation expectations beyond that time horizon have proven to be resilient. So far the back end of the oil curve moved up only $15/bbl. However, we think that once back end prices are moving in a similar fashion to what we currently witness in the front, longer term inflation expectations will likely begin to move up too. In this two part report, we look first at how we got to the current price environment and in the upcoming second part we do a deep dive into the long term outlook for crude oil markets.
 
Oil prices have reached the highest levels since the all-time highs in 2008. The most obvious explanation for the sharp rally is the military conflict in Ukraine and the threat of a loss of Russian oil supplies. However, oil prices are only up $20 since the war started a month ago. In fact, Brent crude oil prices have been rising relentlessly ever since the lows of around $20/bbl we saw during first lockdowns in spring 2020, to $95/bbl just before the invasion (see Exhibit 1).

Long read, but worth reading about oil. The demand for oil from the 2020 COVID lockdowns were more deeper than in the 2008-2009 Recession.

[Ptarmigan]

Long term oil prices beginning to reflect the coming oil shortage – Part II
https://www.goldmoney.com/research/goldmoney-insights/long-term-oil-prices-beginning-to-reflect-the-coming-oil-short-age-part-ii

In this two-part report we analyse the recent moves in oil markets. In the first part we explained the drivers behind the strong rally in prompt oil prices over the past year. In this second part we will take a deep dive into the drivers behind the move in long-dated oil prices and why we think this is just the beginning of a multi-year repricing of the entire forward curve.

In the first part of this report (see Long term oil prices beginning to reflect the coming oil shortage – Part I, 28. March 2022) we explained in detail how we got to the current oil price shock (see Exhibit 1).

Here is the second part. American shale producers have not ramped up. The trends suggest oil shortage could be coming.

So what is driving this? As we mentioned earlier in the report, the short end of the curve is driven by inventories. The long end of the curve is driven by marginal costs of future supply. So why is the market now suddenly pricing in that marginal costs of supply are rising? We think it is a mix of two things. On one hand the market begins to realize that current cost inflation for production is likely not a temporary phenomenon. On the other hand, it dawns to the market that we are going to face supply issues over the coming decade. In the remainder of this report we will take a deep dive into both of these drivers for marginal cost of future supply.

Production cost inflation unlikely to be just transitory

General inflation has been skyrocketing this year. US core price inflation (core excludes energy prices) is at a staggering 6.4%, CPI headline inflation is at 7.9% and Producer Price Inflation (PPI) for finished goods is at a whopping 13.8% (see Exhibit 6).

A lot has been written by economists and in the media about the source of this inflation over the past months. Some argue it’s simply due to supply chain disruptions on the back of worldwide Covid mandates and lockdowns that impacted raw material production, manufacturing and shipping. Some of that is likely true, and as mandates ease, the inflationary pressure from supply chain disruptions will somewhat abate, especially if we are heading into a recession. More important in our view is the phenomenon of excess spending on certain goods that occurred during the pandemic. The lockdown resulted in people having more disposable income and ordering goods online which they wouldn’t have otherwise (see Exhibit 7). This was exacerbated by various forms of Covid relief payments by governments across the world. It appears that people globally spent their money on similar product groups, lots of them manufactured in the Far East. This lead to manufactures struggling to keep up with demand and created shipping bottlenecks. As mandates will gradually be lifted, stimulus checks stop and normalcy returns, those goods flows will abate as well and inflationary pressures will disappear and potentially even reverse. Disposable income per capacity has largely normalized and has now fallen below trend (see Exhibit 7). In other words, inflation pressure from elevated disposable income is coming to an end. And as the Fed is raising rates to combat inflation just as excess spending is ending, this might be just what it takes to push the economy into recession.