In recent days, Brent crude topped $80 per barrel, a three-year high.
Oil analysts are predicting that the global energy crunch that has swept across natural gas, coal, and metals markets will not spare crude oil, despite the still very substantial volumes of crude oil in OPEC+ countries kept offline. The oil bulls are out, but it’s not clear that demand growth can be sustained at high prices, nor is it necessarily favorable to the oil industry to see the rally run too far.
Oil market tightens
The rebound of oil prices this year has been a well-known theme, but the global spike in natural gas more recently has understandably overtaken media attention. Not only are the driving factors pushing up prices related, but the run up in prices on gas could even add to bullish momentum for crude oil.
The extreme spike in natural gas could bleed over into the oil market.
“Brent oil prices have reached new highs since October 2018, and we forecast that this rally will continue, with our year-end Brent forecast of $90/bbl vs. $80/bbl previously,” Goldman Sachs wrote in a note to clients on September 26. “While we have long held a bullish oil view, the current global oil supply-demand deficit is larger than we expected,” the bank said, pointing to faster-than-expected economic recovery from the Delta variant and stagnant supply.
The extreme spike in natural gas could bleed over into the oil market. “[Natural] gas to oil substitution could reach 1 to 2mn b/d if gas prices keep rising,” Bank of America said in a note, adding that a cold winter could add another 500,000 barrels per day of oil demand.
The oil industry is quick to blame rising energy prices on climate policies and too much renewable energy, a disingenuous and opportunistic claim. Today’s shortfall in oil production is the result of multiple factors, but the most significant driver is the two massive blows the industry suffered from the market meltdowns in 2014 and 2020, which hollowed out upstream spending.
Today’s shortfall in supply can be traced back to the pullback in final investment decisions on new sources of supply in recent years. That capped off a decade of U.S. shale drillers losing money, while the oil majors also demonstrated poor and eroding returns.
The pandemic also left a ton of supply shut in even as demand has mostly come back. The U.S., for example, is currently producing nearly 1.5 million barrels per day (Mb/d) less than what it was prior to the pandemic. U.S. oil production rose to 11.1 Mb/d last week, still about 0.5 Mb/d below August levels, prior to Hurricane Ida. But that’s down from the 12.8 Mb/d produced in February 2020.
Global finance is wary of a return to old ways.
Meanwhile, global finance is wary of a return to old ways. As the world reemerged from the pandemic, investors demanded that drillers keep rigs on the sidelines. The rise of ESG pressure has added another element to the mix. ExxonMobil’s loss of board seats earlier this year to activist investor group Engine No. 1 punctuated this trend, one that has forced the entire industry to cut back on spending, make initial (though still inadequate) steps to begin lowering emissions and prepare for energy transition, and otherwise return cash to shareholders.
To be sure, climate policy – and the threat of it – is indeed keeping investment on the sidelines. But investors are doing this because of cold hard profit motives, rather than a desire to be seen as morally righteous. Put simply, why invest in scaling up oil drilling at a time when the world is trying to move on from fossil fuels? The risk of stranded assets rises with each passing day.
Just days ago, for example, Ford announced a big bet on electric vehicles, the latest in a string of decisions by global automakers to banish the internal combustion engine over time. Many major economies plan on completing phasing out gasoline and diesel vehicle sales by 2035.
The rise in prices and the handwringing from energy analysts that oil companies should be stepping up drilling has not changed this trajectory. “Beyond the weather issues, underinvestment remains a theme in commodities, driven by a lack of investor appetite for conventional energy,” Bank of America said in a note. “Investors are simply wary of the poor investment returns of the past decade and green climate policies of the upcoming one.”
That does raise the risk of higher prices, however. The bank said that “tight energy markets could persist for a number of years until the planet transitions to a green energy economy.”
Goldman Sachs said in a separate note to clients that the oil market is shifting “from a cyclically bullish to a structurally bullish” outlook. The bank estimates that Brent will average $81 per barrel next year and $85 per barrel in 2023. The 2023 figure is up $20 per barrel from the bank’s prior estimate.
Goldman analysts said that the current rate that inventories are being drawn down have reached roughly 4.5 million barrels per day, “the largest on record.” The market will struggle to keep up because the “scale will overwhelm both the willingness and ability for OPEC+ to ramp up, with the shale supply response just starting,” the bank said.
Brent is now sitting just below $80 per barrel, and OPEC+ is discussing another increase of supply at its meeting in a few days’ time, perhaps by as much as 400,000 barrels per day.
Bank of America said it could see oil prices topping $100 per barrel next year.
Demand to erode
High oil prices may temporarily lift the fortunes of oil companies, but demand destruction is already setting it, a dynamic that is especially true for natural gas.
Industries worldwide may be forced to curtail operations in the face of extreme prices. “[C]oncerns are growing that rationing of electricity in China could put the brakes on industry there, and thus by extension on demand for oil and gas,” Commerzbank wrote in a note on Wednesday. It is a very painful and undesirable way of reducing demand for polluting industries.
Nevertheless, beyond the short-term extreme pain for consumers of natural gas and crude oil who are suffering from high prices, it is hard to imagine that high prices and extreme volatility offer a strong selling point to maintain the fossil fuel system, especially when clean energy is increasingly cheaper.
Sales of EVs are already picking up pace, and higher fuel prices could add more momentum to this trend. Meanwhile, the U.S. Congress is considering landmark climate legislation at the core of its multi-trillion-dollar budget reconciliation package. High energy prices may be here to stay for the short-term, but that only magnifies the longer-term problems for the oil and gas industry.
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