The other oil cartel

Last week the Saudi controlled OPEC+ cartel infuriated US and European policy makers when they announced that they would be cutting production at a time when oil prices remain relatively high globally and inventories remain low. Much of the cut wasn’t really a cut but an admission that many of the members of the alliance can’t actually produce as much as their respective quotas would allow. But much of the cut will come from where there is spare capacity and that is in Saudi and the UAE. Fortunately, the US has never been more energy independent, with more spare capacity than right now. But there is a problem. The US producers and the US refiners aren’t any more willing to increase production than the theocrats and autocrats who participate in the cartel.

An old friend and colleague told me a story this week that illustrates the point. This friend is an analyst covering energy companies including US based public exploration and production companies or E&P’s. One way sell-side research gets paid by institutional accounts like mutual funds and hedge funds is to organize and host meetings with company management teams on what are called non-deal roadshows. Recently he brought the new CEO of a Texas based E&P to the offices of one of the largest mutual fund complexes in the world. The portfolio manager asked a series of predictable questions about how the CEO intended to allocate the free cash flow the company would generate: how much would go to capital expenditure and how much would be returned to investors in the form of dividends and stock buybacks? When the meeting was about over, the PM told the CEO what his intentions were. He said that he would monitor the company for three years, through up and down commodity environments and if the CEO stuck to the capital discipline promised over that time span, he would consider an investment. If on the other hand, the CEO gave in to the temptation of raising spending in a strong commodity environment, then he should assume that he would never see this investor become a shareholder.

While the bluntness of this particular PM is surprising, the moral of the story is not. Every management team of every E&P knows what the rules are. The manifestation of these “rules” are illustrated below. You can see that while the rig count has gone up (almost entirely by privately owned producers), we are still far below the peaks of ten and fifteen years ago. More recently, with WTI around $90 and natural gas prices hovering at extraordinarily profitable levels, the rig count over the last six weeks has declined.

Most public E&P’s now have formulaic capital return policies from which they are loath to deviate. The average company depending on its maturity will return 50% to 75% of cash annually. The point I’m making is that while US based energy production is not a cartel in that the producers don’t collude to determine output or set a goal for the commodity price, the outcome is essentially the same. They all have the same shareholders who subscribe to the same capital allocation mantra. Energy company management teams who don’t listen to their shareholders, don’t last long.

Below is a chart of where we stand in terms of storage levels. The draining of the SPR has been very effective at bringing down gas prices, but obviously that has limits and at some point, likely shortly after the mid-term elections, that policy will have to be reversed. The draining of the SPR has been effective at bringing down gas prices, but it is a temporary fix. The SPR will need to be refilled and that of course will put upward pressure on oil and product prices going forward.  

The issues of chronic and structural underinvestment are worse and maybe more problematic in the refining space. Last week S&P Global along with the IEF (International Energy Forum) put out a report looking at the long-term trends in global refining. They wrote, “High refining margins in the past led to more investment, but that is not occurring now. The expectation that the energy transition could make refineries stranded assets has deterred investment.”

While capital expenditures have fallen dramatically for the producers, Capex has fallen faster for the refiners. Refining capex has fallen by more than 50% among the independent refiners since 2018 and that trend is unlikely to reverse. As the chart below shows, at some point over the next five to ten years, demand for gasoline will fall as EV’s become a bigger part of the overall fleet. In the long interim period, one can expect periods of spiking gas prices as there simply wont be any capacity available to deal with increases in demand. Making matters worse, there are two countries with the capacity to export gasoline that could alleviate the potential spikes: China and Russia. Good luck with that.

To be clear, I’m not suggesting a moral equivalency of the US energy industry and OPEC+. But, I am making the case that while the US has become far more energy independent, the benefits of that independence are not going to be as disinflationary to the overall cost of energy as one might hope. Energy prices have always been volatile and that will continue, but the long-term trend is higher.

For more on from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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