I am about to discuss a topic that, for reasons that are unclear to me, has been politicized: oil and gas. I am writing this as a pragmatic analyst who looks at two factors: supply and demand. After all, I am not hired by you (IMA clients) to come up with environmental policy, but to grow your wealth.
We are betting that petrochemical prices are going up. Here is why:
Low oil prices before the pandemic were already reducing investments in the industry. The pandemic and negatively trending oil prices only made it worse.
I had a conversation with a friend who lives in Paris, and he told me that French youth despise businesses; they think they are evil. Americans, however, do not have this attitude towards businesses, except when it comes to oil companies.
If you are going to university, becoming a petrochemical engineer is not seen in a positive light, ranking somewhere between a baby seal killer and a garbageman. Imagine a young man asking a father for his daughter’s hand in marriage and being told, “Your job causes climate change.” This is why enrollment in petrochemical engineering programs has decreased by 75%(!).
As older petrochemical engineers retire, there are few qualified people to replace them. This does not bode well for the future long-term supply of petrochemicals.
Oil production in Russia is likely to decline slowly in the long term. Western oil companies left Russia when it invaded Ukraine, and their knowledge went with them.
It gets worse.
Politicians love to vilify oil companies. When oil prices are low, they use them as a punching bag; they are “just damaging the environment.” When oil prices are high, they want to tax their “windfall profits”. Ironically, this caps the potential upside and lowers the present value of many projects, resulting in lower investment in oil fields.
This vilification does not end with politicians. ESG policy puts oil companies in the same uninvestable universe as tobacco companies. If a mutual fund has an ESG mandate (many of them now do), they cannot buy oil (or tobacco) companies.
However, tobacco companies do not need new capital, as they are gushing cash flows and paying them out as dividends (we know this industry well, as we own many of these companies). Oil companies are a different matter. If they stop investing in oil fields, their free cash flows will initially skyrocket but then start to plummet. Thus, this is another reason today, oil companies are not allocating sufficient cash flows to big new projects.
We had a conversation with the management of one of the largest oil companies in North America (not Exxon). Here is what they said:
The difference now compared to maybe in the past is that there are no major projects going on. We are not executing on some of these major capital plans, and neither are our peers. We are optimizing production and having minimal capital programs on projects that are more ‘bite size’ rather than massive. This is a trend that is happening all across North America.
There could be underinvestment and some declines over time, but more importantly, you are not seeing those major projects of 200,000 barrels a day or even 60,000 barrels a day coming on right now. We could double our largest oil field, but it would be a 10-year project and a multi-billion-dollar program. However, the appetite for investors for that would require us to do some convincing.
We don’t know what the carbon world looks like next year, given policy, governments, intervention, and those types of things.
We complain about oil companies like Exxon drilling for oil and damaging the environment, yet we still take planes on weekend getaways and drive cars the size of tanks.
There is an excellent book by Vaclav Smil entitled How the World Really Works, which was recommended by Bill Gates and one of IMA’s clients. Gates is very concerned about the environment and has spent billions of dollars to fight climate change.
It was the client’s recommendation that really surprised me. This client is a lawyer from Texas. Somewhat uncharacteristically for a Texan, when he joined IMA, he asked me not to buy him any oil or natural gas companies, as he felt they were damaging the environment. About a year ago, he told me that after reading this book he had changed his mind about petrochemicals – we can drown his portfolio in petrochemicals if they are good investments. I greatly admire someone’s ability to change their opinion when presented with new data, and that is what this book helps people do.
I will try to summarize the book in a few paragraphs.
Most of our modern society lives very far removed from where food is grown and things are made, so our understanding of how the world really works is distorted by our air-conditioned interactions with the modern world.
We usually think of oil when it comes to powering our cars and natural gas when we pay the bill to heat our house. Petrochemicals are everywhere around us; without them, the world would starve. They are not only used to power combines to harvest wheat and tractors to raise cattle, or to transport these products from the farm to the supermarket, but also, natural gas is the main feedstock for nitrogen fertilizer.
It takes approximately 80 milligrams of diesel fuel to make one kilogram of sourdough bread. Or between 150-750 milliliters of diesel to produce one kilogram of beef. If you are considering going vegan to help save the world, your kilogram of tomatoes would require approximately 650 milligrams of diesel. The same is true for fish, which requires about 700 milligrams of diesel. I could continue, but I think you get the point.
It doesn’t matter what you think about the role petrochemicals play in climate change; our demand for them is not changing quickly, and supply is likely going to decline – thus we will see higher, not lower, prices.
Despite the popularity of electric cars, gasoline and diesel consumption is not going anywhere for a long time, as EVs represent a tiny percentage of the total cars on the road today or in the near future. There are approximately 180 million cars on the road today. We sell approximately 15 million new cars per year. Of those, one million are EVs and the rest are internal combustion vehicles. Even as EV sales increase, it will take a long time before a meaningful portion of the total 180 million is EVs. (I am not even mentioning the 100 million commercial trucks that are switching to electric motors at an even slower pace.)
Demand for natural gas is only going to increase for a long time, for several reasons. First, electric cars need electricity, and this juice will mostly be generated by natural gas. As soon as US LNG export terminals come online (circa 2024/2025), we will be shipping more natural gas to Europe to offset the decline in the supply of gas from Russia.
No, I have not forgotten about new, green sources of energy, such as solar and wind. However, unless we have cheap battery technology to deal with their intermittency (which have not, yet), we will be faced with blackouts when the wind takes a break or clouds block the sun’s rays. Transitioning to green sources of energy is a marathon, not a sprint. We may wish it to be a sprint, but it took us a hundred years to build a global economy that runs on petrochemicals, and it will take us decades to unwind it.
Finally, oil is an interesting hedge on a weakening dollar, which is a likely outcome of our budget deficits.
We have been increasing our exposure to petrochemical companies very patiently and opportunistically. The key with these companies is that they need to be low-cost producers, as they are selling a commodity; and they need to have incredibly strong balance sheets to handle commodity volatility and management that is good at capital allocation. Most mining and oil companies are run by engineers who are simply horrible at capital allocation – they buy high and sell low. To put it bluntly, they want to drill every hole they see, regardless of economics.
We have been very selective; our stock selection looks very different from the mainstream market’s. Also, we need to buy them with a significant margin of safety that discounts a less than optimistic energy price scenario.