The Coming Bottlenecks
This month has witnessed a strong rally in global risk assets (cyclical equities, speculative corporate and emerging market debt, commodities), following the November U.S. election (gridlock), reports of high efficacy rates north of 90% for several COVID-19 vaccine candidates, and optimism that several of these vaccines will receive FDA emergency approval to be available as early as 1Q2021. Investors are even looking past the current 2nd wave COVID-19 outbreak across the northern hemisphere as some are forecasting that we’re approaching or moving past the peak in positive cases (Figure 1).
Figure 1 – Peak in 2nd Wave COVID-19 Cases?
Yet, one of the long-term fallouts from the pandemic-induced shutdowns as well as pressure from governments and institutional shareholders to pursue more environment-friendly green policies is the pullback in long-term capital expenditures for energy exploration. Major integrated energy companies such as British Petroleum and Royal Dutch Shell are focusing more of their future capital expenditures towards alternative energy production with a goal of minimizing fossil fuel production. Some energy analysts estimate that cumulative annual energy exploration capital expenditures have dropped nearly $2.5 trillion since the 2014 oil ‘gold’ rush that saw per barrel prices reach $100. Goldman Sachs estimates that CapEx on renewable energy will surpass fossil fuel CapEx for the first time ever in 2021.
Presumably, this decline in fossil fuel CapEx should actually serve as a long-term tail wind for oil and gas prices, even if consumption declines as more of the global energy demand is met with alternative energy (that is subject to some debate as we discuss below). Global energy market capitalization as a percent of worldwide market capitalization has shrunk to its lowest point ever and energy companies are facing significant resistance, from both shareholders to politicians, as well as ever increasing legal liabilities for committing long-term capital expenditures towards oil/gas exploration. However, oil prices still face near-term pressure due to a lackluster end demand and elevated inventories resulting from the COVID pandemic.
Since the March/April pandemic shutdown that saw oil inventories skyrocket as Cushing spot delivery dropped to negative $40/barrel settlement, oil prices have largely recovered to the $35-$45/barrel range but have not fully participated in the recovery surge seen in industrial metal and agricultural commodities (much of the 2nd half surge driven by China / Pan-Asian demand). Over the near-term, energy (oil and gas) prices will continue to suffer from elevated inventories as 2nd wave COVID outbreaks have dampened transportation consumption.
In addition, Baker Hughes rig counts (Figure 2) are starting to recover leading investors to assume that the North American shale revolution, that comprised nearly 90% of the growth in long-term global supply, will make another 2014-2017 type of comeback resulting in elevated inventories in the face of moribund demand. With respect to demand, as we discussed in our October 2020 Advisor Success Series podcast with Robert Minter from Aberdeen Standard Investments, commercial air travel, which drives a significant portion of energy consumption, will struggle to recover until the business traveler returns, which appears unlikely over the next year or so.
Figure 2 – Moderate Recovery in Baker Hughes US Rig Count and Energy Nonfarm Payrolls Point Towards a Gradual Recovery in U.S. Energy Production Output
But risks of an energy-driven bottleneck arresting a pandemic recovery post-COVID vaccine are building as are risks to other ‘reflationary’ assets, whether they be commodities or global shipping costs.
We had an opportunity to sit on a conference call hosted by Goehring & Rozencwajg Natural Resource Investors (“G&R”) who have been tracking and documenting the productivity decline in North American Shale energy extraction – a decline that has accelerated with the coronavirus pandemic – as a result of prior years of high grading or focusing on the most productive wells that require the least amount of capital expenditures for extraction. For instance, when producers shut down the least productive wells in response to the pandemic, G&R would have expected higher productivity as the more productive wells were kept online, which is what happened between 2014 and 2017. That is not happening today. High grading has resulted in a depletion of the most productive wells, while few producers are willing to commit the high levels of CapEx to maintain drilling with the less productive wells.
Admittedly, the U.S. oil supply picture is very complicated. Inventories moved higher during the pandemic lockdowns with fears of breaching maximum limits. Those fears did not pan out, but wells were shut off and new wells have not been drilled. That took production down quite dramatically in the spring which saw some subsequent re-activation of shut-in wells as prices recovered through the summer and fall. But new wells have not been drilled to offset depletion.
On a well-by-well basis, G&R did confirm the rush of reactivation of shut-in wells but now we’re seeing sequential declines starting in September – all the shut-in wells have now been reactivated but we’re still down year-over-year on production due to a lack of new drilling activity. Prior to COVID, there were 50 drillers in Bakken versus 13 today – basically in wind-down mode. The Permian had over 400 rigs operating at the beginning of the year versus just over 100 today. G&R is hard-pressed to see a path towards sustained increases in production despite a rising rig count. And according to the Bear Traps Report (11/24/2020), the U.S. shale basin was expected to produce 14 million barrels/day this year, but that estimate is down to 11 million bpd as US shale production is seeing major declines without replenishing.
The upshot is that the world could be facing another energy supply squeeze over the next few years barring a major upturn in net new energy capital expenditures to more than offset natural depletion (one analyst estimates the world needs to replace two Canadian oil sands just to keep up with depletion). Indeed, Figure 3 shows one economist’s estimates for the net supply picture.
Figure 3 – Oil Markets Expected to Enter Supply/Demand Deficit Over the Next Few Years
Even the U.S. Energy Information Administration (EIA) is forecasting a deficit in early 2021 (Figure 4), although the agency expects a balanced market assuming more production comes back online, which seems counter to what energy exploration companies are communicating.
Figure 4 – Even the EIA Sees a Net Supply Deficit in Early 2021 as Demand Is Expected to Recover
What about structurally lower levels of oil consumption with the push towards electric vehicle usage and focus on renewal sources? Even if global oil demand doesn’t recover to pre-COVID peak levels of around 102 million bpd, the world could be facing higher transportation costs for the years ahead barring a major shift towards renewable sources, which have their own productivity, environmental impact challenges, especially when one excludes nuclear energy as an alternative source. The global automotive market still runs largely on fossil fuel and diesel, and there does not appear to be a long-term renewal solution for air travel. The COVID-weary population may find social re-engagement to be more expensive.
Alternative energy forms such as renewal sources (wind/solar/hydro-dam/geothermal) are seeing increasing productivity gains but still lack the global scale to compete with traditional fossil fuels. Plus, controversy surrounds the net environmental benefits from sources like wind turbines which require a lot of raw material input (i.e. cement), have short shelf lives (just 20-25 years), and whose blades are difficult to recycle. They also pose their own negative externalities to neighborhoods and wildlife.
Based on recent stock price action, the current alternative energy rage is focused on technologies to manufacture hydrogen (which primarily relies on natural gas, whose production could also be facing a peak in North America, or on coal if it’s produced in China), the main input for electric automotive fuel cells. Unless, nuclear energy is thrown into the mix, manufacturing hydrogen could continue to have a net negative environmental impact based on the amount of energy needed to produce, store, and transport (Ulf Bossel and Baldur Eliasson, “Energy and the Hydrogen Economy”). In other words, “a hydrogen infrastructure is much more energy-intensive than a natural gas economy” In addition, battery electric vehicles require 186 pounds of copper input, twice the amount used for hybrid electric, not to mention the negative environmental impact from mining, storage, and disposal of lithium used in batteries.
So, the world is stuck with carbon-based fossil fuel energy sources until the productivity to produce alternative renewable energy increases to a sufficient scale as to offset the net decline in traditional energy supply that is coming over the next few years, barring a major upturn in long-cycle CapEx spending.
Other emerging bottlenecks to a post-COVID recovery.
Bloomberg reports of a “squeeze in global grain markets” due to strong demand from China and smaller-than-expected harvests (Figure 5).
Figure 5 – Agricultural Commodities Such as Grains Have Experienced a 2nd Half Surge in Prices
As global trade activity recovers, the cost to ship global products has also soared (Figure 6) due to a squeeze in available shipping.
Figure 6 – Shopping Around for Global Shipping Is Increasingly Hard to Come By
And thanks to historically low interest rates, bottlenecks are forming in the U.S. housing market as months’ supply of inventory hit a record low of 2.5 months (Figure 7).
Figure 7 – Housing Inventory Hits Record Low Based on Current Sales Pace
The world may be exhausted with COVID-19 and enthusiastically looking ahead to post-pandemic normalization, but this lockdown-induced pent up demand could hit a wall as the combination of capital expenditure destruction and historically low interest rates (along with record government deficit spending) could produce a cost-of-living environment squeezed by an ever increasing list of bottlenecks.
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By: Benjamin Lavine