December 12, 2021
- Does QE Cause Wealth Inequality?
- Proof-of-Stake and Stablecoins: A Blockchain Centralization Dilemma
- Swan Bitcoin Review
This newsletter examines the history and current state of the global oil market, and makes the case for decent performance from oil and gas stocks during the 2020s decade.
It’s not a trading call, in the sense that all sorts of variables such as virus variants and government policies and OPEC+ decisions can affect any given 6-12 month period. But rather, it’s a look into the structure of the market itself with a view over a multi-year commodity cycle.
The Central Importance of Oil
For better or worse, it’s hard to overstate how important oil, gas, and coal are for the world’s energy mix:
Chart Source: Our World in Data
Together, fossil fuels represent about 79% of global energy consumption. Wind turbines and solar panels together are only about 3% (and are made using fossil fuels). The rest consists of biomass, hydro, nuclear, and other forms of energy, which we mostly build using construction vehicles that run on fossil fuels and that were manufactured using fossil fuels.
What makes fossil fuels so powerful is that they have high energy density and a high energy return on investment, since they represent stored-up solar energy from ages long past.
Nuclear, hydroelectric, geothermal, and fossil fuels use stored-up and/or concentrated energy in various ways, either atomic, gravitational, or chemical. Most other types of power production, such as wind and solar, instead try to harness nature’s current work flow rather than letting nature present it in a denser form, which is why they have challenges related to intermittency, as well as high costs (including additional environmental costs) when you take into account the storage that is needed to reduce that intermittency.
I wrote a public research piece about this in June 2021 and since then we’ve seen energy crises in Europe and China faster than I would have guessed.
Europe, for example, has had major issues getting enough natural gas lately, resulting in a massive and relatively persistent price spike:
Chart Source: Trading Economics
Tapping into dense forms of energy is what allowed for a period of exponential technological gain, average human lifespan extension, and global poverty reduction.
With vehicles, we could travel far distances and mechanize our agriculture so that ten people could harvest enough food to feed a thousand people, which freed the other 990 people to be productive elsewhere and create new things. With pumps, we could provide most people with clean water and sanitation, which vastly reduced disease transmission. With electricity, we could power our homes with all sorts of machines that keep our food cold, wash our clothes, and provide us with light during the night, as well as power factories that produce complex things very cheaply. With natural gas we could heat our homes in the winter months, and generate electricity to cool our homes in the summer months.
Plus, petrochemicals are used for a surprising number of materials we interact with:
Chart Source: Enterprise Products Partners 3Q 2021 Presentation
This chart shows that global GDP (which is adjusted for inflation) broke out basically along the same trend as our fossil fuel use, when humanity began using coal and oil:
Chart Source: Our World in Data
For many centuries to the extent that data can be estimated, economies grew rather slowly. And then like a light switch turning on, humans figured out how to find and harness the power of these dense energy sources, and economic growth has been exponential ever since.
Each individual barrel of oil literally contains years of human labor, when you break it down quantitatively.
Specifically, a barrel of oil can be used to send a medium-sized car 280 miles, plus send a large truck 50 miles, plus power a home for a couple days, plus make a huge variety of products with the rest of it.
If we simplify that list and think in terms of purely how many joules of energy are in a barrel of oil, rather than the actual refining breakdown into all of those parts (gasoline, diesel, propane, petrochemicals, and so forth), a barrel of oil contains enough energy to send a small car close to 1,000 miles. Imagine how many human labor hours it would take for a group of people to push a car 1,000 miles.
The average American consumes over 20 barrels of oil per year in various ways, plus even more than that from other forms of energy combined like gas, oil, hydroelectric, and more. The average American therefore has an unfathomable amount of human labor equivalents helping them in their lives, like enough labor to push a small vehicle around the circumference of the Earth once or twice each year. All of this labor is mostly in machine form and so we don’t necessarily realize how much work is being done for us. The numbers vary by country but even in many developing countries, people have a tremendous amount of work being done for them due to fossil fuels.
This comes with major costs, of course. Coal emits particulates, which contribute to smog, oceanic mercury, and other environmental problems. Gasoline-powered vehicles emit particulates in densely-crowded cities. Coal, oil, and gas all emit CO2 into the atmosphere, and atmospheric levels of CO2 have broken out to more than a million-year high, which is above any normal cycle. We have to go back a lot further to find levels this elevated:
Chart Source: NASA
Plastics made from petrochemicals are spilling into our oceans at an alarming rate. Fertilizers, vehicles, and other modern agriculture techniques powered from petrochemicals are resulting in big monocrop fields, thin soil, and oceanic dead zones.
All together, the world is experiencing a rapid reduction in biodiversity, which is a polite way of saying we may be in the sixth mass extinction event in terms of the percentage of total species that are going extinct over a rather compressed time period by evolutionary standards. Not all of that is related to fossil fuels but these fuels certainly increase our power by orders of magnitude to impact global life, which can circle back to supporting or not supporting our own lives if we don’t wield that power well.
Basically, humanity has relied on high-time-preference thinking for many decades now, which means we have aggressively discounted the future in favor of the present. However, even for recent attempts to shift towards “renewables”, it’s often more like greenwashing or Kabuki theater, meaning the efforts are more about looking green than building truly sustainable systems. Solar, wind, and associated power storage systems still have a ton of shortcomings and we have often deployed them into regions that they are not ideally suited for in order to score “green points”.
The worst case scenario is that this huge boom in the quantity and quality of human flourishing over the past two centuries enabled by fossil fuels all ends up being just an ephemeral spike, and that the full costs come back to slam us over the next two centuries.
A moderate case scenario is that humanity’s ability to tap into dense forms of energy eventually hits a plateau for one reason or another (e.g. we run into peak fossil fuel production, and don’t get better energy technologies online fast enough). For the past two centuries, humans have had a rapidly growing energy/resource pie and still managed to find things to fight wars over. Imagine how conflicts could escalate if that pie stops growing and energy/resources become a zero-sum geopolitical game.
So, humans may have a challenging road ahead with energy. Fossil fuels support billions of human lives, but do come with costs. Some of those costs are immediate but non-existential (e.g. city atmosphere pollution), some costs are intermediate-term and global (e.g. oceanic mercury), and other costs are long-term but may cause potentially exponential problems (e.g. we might not want to hit 1,000+ CO2 parts per million in the atmosphere, and aren’t sure of the full consequences for what exactly that means if we do since some of the run-off effects are challenging to model).
The replacements for fossil fuels are not as efficient as often described, when you take into account intermittency and storage and how much battery metals are required for those types of solutions (for which the mines are generally environmentally damaging, and are dug up and then manufactured using equipment that runs on fossil fuels). As a former electrical engineer, I wish these solutions were more efficient, but they simply aren’t due to lack of energy density unless we have some major breakthroughs in material science. Instead, they are mainly ideal around the margins for complementing our more stable base load power, and can be a bigger percentage of power production in certain ideal regions.
New forms of nuclear energy have promise, as do some other forms of power generation. The key thing in common is that they tap into a dense energy source that is reliable. And although it’s not yet widely understood, if the Bitcoin network continues to be successful, bitcoin mining equipment can be integrated into stranded and intermittent energy sources more closely to improve the economics of those energy sources, as I described here. In some areas, that’s already happening.
I also think the study of carbon will continue to advance. A lot of emphasis is placed on reducing carbon emissions but perhaps not enough emphasis is placed on improving carbon sinks. The world’s soil, for example, contains 3x as much carbon as the atmosphere, and anything we can do to improve soil depth (basically the opposite of modern, industrialized, monocrop, annual farming techniques) may be able to sequester quite a bit of carbon over the long run.
So, the ideal case scenario is that humanity continues to harness new forms of dense energy, shifts to longer-term thinking, and starts doing things in more sustainable ways.
The Five Ages of Oil
From 1870 until 1911 when it was broken up, Standard Oil was the dominant oil producer. This can be considered the first age of oil.
Then there were the world wars, after which emerged the second age of oil where the “Seven Sisters” controlled the majority of the world’s oil reserves. The term “Seven Sisters” was a reference to the mythological daughters of the titan Atlas, and consisted of the seven largest American and British global oil companies, many of which were remnants of Standard Oil. They acquired oil reserves internationally, and this period lasted until the 1970s.
In 1970, US oil production structurally peaked for the next four decades:
We then entered the third age of oil, which was the rise of OPEC, which went from the 1970s through the 2000s. State-owned oil companies in the Middle East and elsewhere began to play the dominant role in global oil markets. The US structured its petrodollar system around that focus, and since then countless military conflicts have occurred throughout the Middle East, some of which certainly influenced by oil and the associated geopolitics around that oil.
For the fourth age of oil, starting in the early 2010s, cheap money and technology advancements allowed previously uneconomic oil to be recovered. The US resurrected its oil industry in the form of “shale oil”. This by no means became the dominant source of global oil, but it was enough to tip the balance and temporarily interfere with OPEC’s control over global oil.
However, most of that shale oil was never truly profitable. Shale oil companies were often not free cash flow positive despite making all of this new production; they were issuing debt and equity to drill for oil, and then not recouping their full expenses. And because interest rates were so low, pensions and investment banks were happy to keep giving them capital. Plus, shale oil wells come online quicker but then also deplete quicker. With shale oil, the producer has to constantly inject capital to maintain the same level of production, let alone grow it.
I contend that we’re entering a fifth age of oil, where shale oil will be more restrained (and profitable) and where OPEC+ (including Russia now) is gaining some dominance again, but not really growing and not making massive new discoveries either. Various research organizations place the maximum realistic US oil production level at 13-18 million barrels per day before it starts entering a structural decline. It’s possible that prior highs of about 13 million were already the peak, but it’s also possible that we’ll reach somewhere in that higher range if high energy prices call for it.
Meanwhile, various ESG mandates are preventing large pools of capital from investing in oil and gas companies. Many pensions, sovereign wealth funds, and other pools of capital are divesting from oil and gas companies or have already done so.
This is making oil and gas companies more prudent with drilling. Unlike the 2010s decade where they kept lighting money on fire to drill unprofitably, now many companies are very disciplined with their capital. Their incentives from shareholders are now to be as self-sufficient as possible, meaning that new capital expenditures come out of their profitable drilling activities. Rather than wanting to rely on external financing, these companies want to pay down debt, buy back shares, and pay out dividends to shareholders.
EOG Resources Example
I often like to use EOG Resources (EOG) as an example because it was one of the best-performing shale companies in terms of being disciplined with drilling and avoiding too much shareholder capital destruction.
And yet during the shale boom of the 2010s decade, EOG still took on billions of dollars in net debt:
And produced negative free cash flow:
In recent years, however, we can see that it’s a very different story. Their drilling discipline is much higher, they rapidly paid down debt, and are focusing on being free cash flow positive. They are harvesting from years of investment rather than plowing more and more money into the ground at any price. A lot of the money is going towards dividends now.
And this is the case with most significant oil and gas companies around. Their newer approaches are mostly about restraining production growth, strengthening their balance sheets, giving capital back to shareholders, and in some cases getting into other lines of business like wind turbines and electric charging stations.
Despite record free cash flow and dividend payouts currently, and that they are doing a good job of replacing their reserves, EOG’s share price is lower than it was 7 years ago. And that’s better than many energy stocks that are below their highs from 13 years ago.
Considering the fact that valuations in the oil and gas sector remain cheap globally, I view the 2020s decade as likely being a decent decade for oil and gas stocks. Demand growth isn’t particularly rapid, but it’s the supply side that is interesting. A decade of unprofitable shale oil growth threw energy markets out of balance towards excess supply for a long time, but I believe they are getting back into balance, and if anything, potentially a lack of balance towards high prices and shortages.
This is not a trading call; I have no idea how the Omicron virus variant, OPEC+ decisions, economic contractions, or any other variable could affect demand over a given 6-12 month period. Instead, it’s a secular view about the full decade.
The oil sector today looks a lot like the tobacco industry of the 1990s. I hate tobacco stocks because unlike energy, they don’t actually serve a public good. All tobacco products do is kill, whereas the energy sector comes with environmental downsides but also enables human flourishing.
Back in the 1990s, smoking was on the downtrend, and people assumed that tobacco stocks would underperform going forward. They were super cheap. What happened? Tobacco stocks went on to outperform over the next few decades. Being cheap made their share repurchases and dividend reinvestments more impactful. They compounded value at a fast rate despite secular stagnation, and their prices went up from lack of competition.
I see a similar outcome for oil and gas stocks. I don’t expect raging supply or demand growth, but I expect relatively tight supply, along with a lot of capital returns.
Here’s the chart of the Nasdaq 100, priced in barrels of oil:
And here’s the log version of the chart that is more clear:
We see over time that the Nasdaq outperforms, as tech equities are able to compound value while a commodity cannot. However, it goes in big cycles. The 1970s were very commodity-inflationary, while the 1980s and 1990s were commodity-deflationary. And then the 2000s were commodity-inflationary again, and the 2010s were commodity-deflationary again.
Here’s a chart of the S&P energy sector total return index vs the S&P 500 total return index. When it’s going up that means energy stocks are outperforming, and when it’s going down that means energy stocks are underperforming:
In the 1990s, the energy sector lagged as Japan and emerging markets ran into growth headwinds.
In the 2000s, the US dollar weakened and emerging markets had a growth boom, which resulted in a big increase in oil demand.
In the 2010s, many countries went through a private sector deleveraging, the dollar strengthened, emerging market growth slowed, and unprofitable US shale oil flooded the market.
For the 2020s, the book is not written yet, but my base case is towards tighter oil supply and decent energy sector performance. It might not be a “boom” like in the 2000s, but rather a long grind from low valuations with high dividend payouts accumulating over time while higher-valuation stocks sag a bit.
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
I increased MSTR compared to MARA in the digital assets pie, and made other small tweaks to holdings.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus I have larger personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Entering a Tightening Cycle
Many emerging market central banks have been tightening monetary conditions throughout 2021.
For some examples, Brazil raised their short-term interest rates from 2% to 9.25% and Russia raised theirs from 4.25% to 7.5%. Even some developed market central banks have already tightened a bit, including Canada that stopped quantitative easing this autumn, Australia that ended its yield curve control, and Japan that slowed down their balance sheet expansion.
The US Federal Reserve and the European Central Bank have been among the most dovish of central banks during the past couple of years, but the Fed is next in line now that it is slowly reducing its rate of quantitative easing.
If you look back decades in US stock market history, stocks generally did quite well whenever the Fed was tightening monetary policy with interest rate increases. It’s not that rate hikes are good for stocks; it’s that the Fed hikes rates when the economy is strengthening, and that strengthening economy is also good for stocks. It’s kind of like how shark attacks and ice cream consumption have a pretty close correlation… because they both have an uptick in summer.
The outcome changes if you narrow the analysis period to the time after the global financial crisis, starting around 2010 or so. Whenever the Fed held its balance sheet flat, and whenever the federal government was not actively stimulating, stocks generally chopped along sideways. Their upward periods were quite correlated with either monetary or fiscal stimulus occurring.
S&P 500 quarter-over-quarter revenue growth is decelerating, and operating margins are rolling over a bit. This chart from Charlie Bilello provides a great two-decade visual:
After such a strong year for equities in 2021 amid major fiscal and monetary stimulus, my base case is for a less-spectacular 2022. That doesn’t necessarily mean I am expecting a big crash, but simply that the combination of high valuations, declining margins from high levels, and withdrawing stimulus leads me to think somewhat defensively as far as the major indices are concerned.
I continue to like several stock sectors and industries, such as healthcare, energy, and homebuilders. There are plenty of places to deploy capital for investors that have a long-term view.
My preference is towards companies with strong balance sheets and substantial economic resilience, along with some TIPS, international equities, and various alternative investments.