Expectations are growing that oil prices will rise further. The most recent rise was prompted by suggestions that the West would boycott Russian oil and gas, a boycott that materialised with US and UK decisions on Wednesday.
Prior to the invasion of Ukraine, the most pessimistic scenario was that Western Europe would no longer have access to Russian oil and gas. Europe is hearing more and more calls for a voluntary boycott of Russian energy. EU climate chief Frans Timmermans even goes so far as to advocate the use of coal.
Demand exceeds supply
Even before the war in the Ukraine, 2022 already was the first year in history that there is more demand than supply in terms of oil. This is unprecedented in the more than 150-year history of oil history in the extraction of oil.
In recent years, Saudi Arabia has always had spare capacity. Now Opec is struggling to meet its promised monthly production increase of 400,000 barrels per day. With luck, Opec will reach 240,000 barrels a day. And it is not going well because Russia is included in Opec+.
Putin is capable of a lot, but so far there is no question of an oil and gas boycott. It is remarkable that the rest of the world now wants to boycott Russian raw materials. It is the world upside down.
Last week, Shell managed to stockpile Urals oil at a discount of 28 dollars to the market price, but the company was immediately held to account and eventually had to promise to donate the proceeds to charity. Major consumers of Russian gas are voluntarily terminating their contracts and many local governments no longer want to have anything to do with Russia.
Energy stocks extremely low
Furthermore, oil stocks, as well as gas and coal stocks, are extremely low. Worldwide stocks have been reduced all year to meet demand. Capacity will be limited in the short term, especially since investing in oil production in recent years has not been very popular in recent years.
The number of drilling rigs in the US is still about 30 percent lower than it was before the start of the pandemic. This makes the number of drilling rigs similar to 2016, despite oil prices being at their highest level in seven years. The pain threshold has not yet been reached.
Oil prices can only stabilise when demand falls off. Now, energy is a basic necessity, so demand for it is fairly inelastic. Furthermore, governments are going to massively subsidise fossil fuels otherwise consumers will be hit too hard. The pain threshold on the demand side of oil is therefore much higher.
After the oil shock of 1973, the oil price tripled in three months. Oil prices doubled again in 1979 after the Iranian revolution. We are now only at the level of seven years ago and still below the level of 14 years ago. A real oil shock would occur if the price of oil doubled from its current level.
Climate no longer matters as much
Releasing strategic reserves has a psychological effect. It is a one-off action, mainly inspired by the idea that oil prices could rise further, but it can also look like a desperate move. The fact that all those fossil fuels contribute to the climate crisis is no longer given much weight. For a while now, energy security is taking precedence before the energy transition.
The last time the oil price was at a record level was July 2008. Then the Great Financial Crisis put a stop to demand for oil. Now the world economy is opening up again because of the end of the coronavirus pandemic. We will fly again, although flights around Russia are taking longer these days and that, too, is consuming energy.
What is not taken into account is the loss of oil supply. Many shale producers are not prepared to invest more in this high oil price either. It is very difficult nowadays to finance such a project. Furthermore, a shale field does not have eternal life; on average, such a field lasts ten years.
Russia cut off from essential technology
The fact that Russia is now cut off from essential technology to produce oil is also bad news. The same thing has happened to Venezuela. In the year 2000, Venezuela was producing 3 million barrels per day. This year, they will be lucky if they reach 500,000 barrels a day. The Russian oil and gas infrastructure is capital-intensive and suffers more and more from melting permafrost. The Russians have extensive shale fields, but do not have the technology to extract them.
Companies like Gazprom and Rosneft are, in fact, state-owned, and they are not known for their efficiency. They spend 0.02 per cent and 0.09 per cent on research and development, a fraction of what western oil companies spend on it. As a result, revenue per well fell by 13 percent between 2008 and 2019. Until recently, the Russians were only too happy to work together through joint ventures with Western oil companies, which supplied the technology.
Without Shell, no LNG tankers would leave Sakhalin. Now that Shell has pulled out of the project, the Russians can do the maintenance themselves.
Conclusion
There is nothing to suggest that oil prices will fall. Of course, a quick peace in Ukraine could cause the risk premium in the oil price to melt away, but the demand for oil will continue to rise in the coming years. The number of consumers with purchasing power will double this decade and 90 percent of that growth will come from Asia.
As soon as these consumers have enough to spend, their energy consumption will increase rapidly. Not just for heating or cooling their homes or for transport, but especially for all the products they buy. If you look at the world around you, you will see that basically everything is energy.
In this respect, it is strange that energy companies still make up only a few percent of the world index. Almost nowhere else are such cheap cash flows generated. Only with these cash flows is the energy transition possible, and without the army of engineers with the knowledge of large-scale projects that the oil companies have in-house, the energy transition will remain little more than tinkering on the margins. These companies are central to short-term energy security and long-term energy transition.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. Dieperink provides his analysis and commentary on the economy and markets.