“This one will really take you back,” said the Great Winfield. “Sheldon’s Western Oil Shale has gone from three to thirty.”
“Sir!” said Sheldon the Kid. “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It’s selling at twenty-four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”
“Shale oil! Shale oil!” said the Great Winfield. “Takes you way back, doesn’t it? I bet you can barely remember it.”
“The shale oil play,” I said dreaming. “My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…”
“See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvellous! It’s like having a son! My boys! My kids!”
The Great Winfield had made his point. Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before.”
– Excerpt from The Money Game (1976) by Adam Smith (aka George Goodman)
Muscle Memory: Misnomer
Complicated skills that humans can overtime perform without much thought, almost automatically, such as riding a bike, playing the guitar, or knitting a sweater, are often thought of as being held in muscle memory. Think back to Karate Kid and Mr Miyagi’s ‘wax on, wax off’ training regime – popular culture fed us the idea of muscle memory and we gobbled it up.
While it is true that certain skills may require the strengthening of various muscle groups, the reality is that learning and retention of new skills occurs in the brain, not in muscles. The process of acquiring new skills causes changes to the structure of the brain. Magnetic resonance imaging (MRI) scans reveal that there is a visible increase in the number of the connections between the different areas of the brain that are required for the skill being acquired. This structural change alters the information the brain transmits to the muscles, thereby altering the movements produced by the muscles.
Ideas: Power
The ability to imagine a reality that neither exists today nor has existed in the past, to give birth to an idea, is one of the truly remarkable gifts endowed to humanity.
Ideas are the seeds of progress. It is ideas that enable large scale human cooperation that transcends self-interest, race, and borders.
Simple ideas: Highly contagious
Ideas are powerful. Simple ideas that are fully formed and easily understood are also highly contagious. Once a simple idea has taken hold, it is difficult, almost impossible, to eradicate.
Peak oil was a simple idea and it was easy to understand, making it both powerful and contagious. It was so contagious in fact that it bordered on belief; it was hardly ever questioned. And the parabolic rise in the price of oil during the last decade was taken by many as confirmation of that belief.
So when the price of oil crashed during the second half of 2014, the immediate reaction of the global investment community was not that peak oil was a myth but rather that OPEC (read: Saudi Arabia) had been greedy. That the cartel had artificially kept supply constrained to maximise its earnings and that the greed had comeback in the form of shale to bite the cartel in their proverbial behind.
The resilience of the peak oil concept is the very reason we think that oil prices recovered sharply during the first half of 2015 and that dedicated energy focused private equity funds were able to raise so much capital in a relatively short amount of time. As market participants witnessed the sharp drop-off in rigs across shale oilfields, it reminded them that cheap oil would eventually run out and higher prices would be needed to satisfy global oil demand – muscle memory or not, investors proceeded to bid up the price of oil.
Ideas that have taken hold in people’s minds are difficult to eradicate. And this is precisely the reason why an even sharper drop in the price of oil was needed to debunk peak oil as a myth. As oil prices tanked during the fourth quarter of 2015 and January 2016, a new idea took hold: the existence of shale placing a cap on the price of oil, i.e. if oil prices were to move above an arbitrary price, usually quoted to be between US dollar 65 to 80 per barrel, for a prolonged period of time, shale producers would ramp up production and flood the market with excess oil.
As oil prices recovered during 2017 so too did US oil production – US output has climbed by approximately 1.2 million barrels per day since January 2017. This surge in production is being seen by many as confirmation of both the responsiveness of shale oil producers and the existence of a cap on the price of oil. We beg to differ.
Investment Perspective
While the surge in US shale production has been impressive and may well continue for the remainder of 2018, we consider the supply and demand dynamics of oil to be decidedly in favour of steady or higher oil prices over the medium term:
- The cyclical upturn in the global economy has supported oil demand, which grew by around 1.6 million barrels per day in 2017 and based on OPEC estimates is going to grow by a similar amount in 2018 and reach almost 100 million barrels per day.
- Even though US shale oil production is increasing, it is not overwhelming the market. Suggesting that shale production is not exactly like a tap and that there may even be infrastructure related bottlenecks that constrain supply growth.
- The anticipated phasing out of the combustion engine by electric powered vehicles, we think, will take far longer than oil bears expect. Beyond the intangible benefit – at least at an individual consumer level – of doing what is good for the environment, consumers receive very few, if any, tangible benefits in switching to electric vehicles. (We accept that there are some notable exceptions in countries where governments have incentivised electrical vehicle adoption through tax breaks, subsidies, etc.)
There simply are not enough electric vehicle charging stations across any automotive market of meaningful size. Any large scale roll out of electric vehicle charging stations would, in our opinion, have to be subsidised, directly or indirectly, by governments as any such roll out does not, at this stage, make commercial sense, even as an industry-wide joint effort.
- China has been a strong proponent of electric vehicle adoption over the years.
China’s recent pollution crackdown, at face value, also appears to be a continuation of its policy of promoting electric vehicle adoption. The reality, however, is that the crackdown has placed immense pressure on China’s already limited natural gas supplies, fuelled discontent amongst its citizen and driven China to import record amounts of LNG.China simply cannot afford for the adoption rate of electrical vehicles to accelerate. We, therefore, think that China is likely to gradually phase out any remaining incentives for electric vehicle adoption as opposed introducing further incentives promoting adoption.
In addition to the above we do not think the market is fully pricing in the potential disruptions to supply from:
- A collapse in Venezuelan crude production;
- The increasing probability of the Trump Administration pushing through reinstatement of economic sanctions on Iran;
- Sustained cooperation between Saudi Arabia and Russian in managing supply; and
- Slashed exploration and production budgets across the non-state owned oil majors.
Positioning in futures markets remains stretched, making the price of oil susceptible to a sharp correction, especially if trade war rhetoric continues to ramp-up between the US and China. We would see any such correction as an opportunity to build a position in our most favoured oil plays.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.