Barron's Streetwise - $5 Gasoline? Where Russia's War Could Take Oil

Episode Date: March 4, 2022

A top commodities strategist lays out the prospects for new supply--and demand destruction. And an oil CEO doubles down on his pledge to limit new drilling. Learn more about your ad choices. Visit megaphone.fm/adchoices

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until those troops are back in their barracks. Welcome to the Barron's Streetwise podcast. I'm Jack Howe. The voice you just heard is Halima Croft. She's the head of commodity strategy at RBC Capital Markets. If you want to know something about geopolitics and oil, you want to talk with Halima. Texas crude recently shot more than 20% higher in a week to prices we haven't seen in more than a decade. What does that mean for gasoline? How high will oil go? And besides Russia, who's to blame? Environmentalist investors, pipeline opponents, U.S. shale drillers, Saudi Arabia? That's coming up. Plus, I have an update from an oil CEO we've heard from

in the past. Listening in is our audio producer, Jackson. Hi, Jackson. Hi, Jack. I don't know what you have for banter this week. I don't have a whole lot. I am distraught over the suffering in Ukraine. I'm watching an unhealthy amount of cable news. I'm checking Twitter headlines pretty obsessively. In a perfect world, I would not be learning this many details about Molotov cocktails and the difference between Stinger and Javelin missiles. I'm pretty much waking up about three hours too early every morning now and checking my phone, hoping the bombing has stopped or that the Ukrainians have at at least held on jackson how are you coping with all this there's a news website

that only puts up positive news sometimes i look at that all right we'll try a couple of headlines tiny new species of chocolate frog is discovered after scientists follow its unique beep sound. Pretty long headline. I'll pass. What else do you have? Baby born 2-2-22 at 2-22 a.m. in room two. That's okay, I guess. How about sneaky cat swings on handle to open door for all his friends? Why don't you email me that one?

Will do. Oil has taken a dramatic turn over the past two weeks, and really, it's had a remarkable past two years. We started this podcast close to two years ago. The week pandemic lockdowns began.

Our fifth episode was titled The Week Oil Got Weird. Because if you remember, Texas crude briefly reached a low point of negative $37 a barrel. It was a fluke of futures trading. Highways had all but emptied of drivers and oil storage facilities were full. Traders couldn't accept more oil at any price. That situation was short-lived and the oil price recovered. But for the rest of 2020, Texas crude didn't break above $50 a barrel. Some U.S. drillers fell into financial distress.

Last year, life began to return to normal here and there with plenty of interruptions from resurging COVID cases. Oil demand picked up. Supplies were short. By late this past January, oil had hit $85 a barrel, and energy stocks were the darlings of Wall Street. We spoke on this podcast with Rick Moncrief, the CEO of Devon Energy, one of the top U.S. shale drillers. His stock was up 178% last year. Remember what Rick told us when I asked about whether he planned to raise production now that oil prices were back up. Rick said at the time that investors were demanding production discipline and that he

would limit production growth to no more than 5% this year. Companies like ourselves, we've had some head fakes where commodity prices really rallied only to see too much activity or in the case of an event like the Black Swan of the pandemic. So those are pretty sobering facts. And so I think that discipline is going to stick. That's what our story is going to be, I can assure you. Things have changed a lot since then. I certainly didn't expect this war or that the world would all but shut down the Russian economy, including much of its oil trade. Oil shot above $110 this past week.

Oil shot above $110 this past week. To put that into historical context, oil has been more expensive only twice before, if we adjust for inflation. Once was during the 1970s. Egyptian tanks and helicopters crossed the Suez Canal while Syrian forces moved on the Israeli-occupied Golan Heights. When the Yom Kippur War, and later the the Iranian Revolution interrupted the supply of Middle East oil. President Carter and other Western leaders agreed in Tokyo to limit oil imports to try to reduce dependence on OPEC. Setting off two oil shocks, or price spikes. As might be expected, the longer the line and waiting time, the angrier some motorists became.

There's no shortage. I don't believe there's a shortage. Both led to recessions. The other period when oil was more expensive than now, the all-time peak really, came in 2008. Oil soared to a peak of $147 a barrel. War did not play a big role then, nor did natural disasters or any other supply interruptions. One popular explanation at the time was that futures traders had just gone wild with speculation. But since then, economists have attributed the rise to something simpler. Years of stagnant production combined with fast global demand growth for oil, especially from China. What followed was a rapid plunge in oil prices during the Great Recession, which is commonly blamed on a collapse in house prices,

but some economists believe that the 2008 oil spike played a big role in the Great Recession, too, because it caused U.S. consumers to pull back on spending on cars and other goods. Okay, so as unlikely as this question would have seemed a year and a half ago, could we be on the way to testing all-time highs for oil prices? And who's to blame for not creating more supply? I know just the person to ask. Hi. Hi, Halima. Jack Howe from Barron's.

How are you? That's Halima Croft. She's the global head of commodity strategy at RBC Capital Markets and an expert on the geopolitics of oil. And she points out that the oil market was already tight before Russia invaded Ukraine, and there were already concerns about keeping up with demand. What we're seeing now, she says, isn't technically sanctions on Russian oil. It's more like a buyer's strike. in Washington say we are not looking to sanction oil and gas exports because we don't want to exacerbate an already precarious supply and demand dynamic. But what we've seen effectively

since the fighting commenced is a buyer strike or self-sanctioning by major energy market participants who are basically saying, A, I don't want to be accused of fueling this conflict. And B, we are concerned that the sanctions that have already been imposed targeting the central bank, key financial institutions could make it difficult for us to operate. And we also are concerned that come a week or two from now, we will see the type of sanctions that were put in place on Iran that prohibit importing countries for taking those barrels.

And so I think they see the direction of travel on sanctions and are concerned, and they just don't want to be associated right now with this ongoing military action in Ukraine. So we've had a number of the most important participants withdraw from Russia. BP, Shell, Exxon, and Equinor, the state oil company of Norway, have announced they will exit projects in Russia. Many shipping

companies, including tanker fleets, have halted business with Russia to manage sanctions risk and reputational risk. Russia is far from an economic heavyweight. Its stock market had only around a one and a half percent weighting in emerging markets index funds, smaller than Thailand. And now some indexes have kicked Russia out. U.S. imports from Russia are negligible, almost. We do buy Russian oil. Now, I know that sounds odd. The U.S. is the world's largest oil producer. Why would we import oil from Russia? Two reasons. The first is geographical. When I referred to Texas crude earlier, I was talking about West Texas Intermediate, which comes from Texas and New Mexico and

gets delivered to a town called Cushing in the landlocked state of Oklahoma, which is not the least bit convenient for oil markets on the east and west coasts. What is convenient to Cushing is the port city of Houston, Texas, which is connected by pipeline. But you can't generally ship oil from Houston to New York or Los Angeles because of an archaic law called the Jones Act, which greatly restricts the types of ships that can travel between U.S. ports. So coastal markets buy imported oil.

But even the Gulf Coast imports some Russian oil, and that has more to do with grade. Texas crude is light and sweet, which refers not to the taste but to the sulfur content. It's lovely stuff. Russian crude is heavy and sour. It's more difficult to refine. But some refiners build plants specifically to take advantage of the price differential or supply differential on heavy sour crude. So some of them buy that type of crude to maximize capacity or profits. It's kind of like how Arabica coffee beans are clearly better than Robusta coffee beans, but espresso blenders will throw in a smidgen of Robusta for strength and body. It's nothing like that. But suffice it to say that the U.S. is a net importer of crude oil and a net exporter of refined products like fuel, and that if you

count both crude and refined products, imports and exports are about even. Of the imports, Russia makes up 8%, more than Saudi Arabia, about the same as Mexico, and a lot less than Canada. But even though Russia is not a huge supplier of ours, in a tight market, cutting imports of its oil could have a big effect on price. That's why the sanctions don't yet cover oil, although they might soon, and there are reasonable cases to be made both ways. By the way, investment bank Stiefel calculates that removing Russia from the oil market entirely would result in a price of $200 a barrel, something they conclude is unlikely. B of A Securities recently estimated that a $200 a barrel oil price would subtract two percentage points from U.S. economic growth.

That could set off a recession. For now, as Halima says, companies appear to be self-sanctioning. The latest national average gasoline price is $3.84 a gallon. Prices appear likely to hit $4 soon, and they might already be there where you live. San Francisco recently became the first city to top $5 a gallon. So how high will oil prices go? Here's Halima. I think that will basically be a function of how much oil production do we lose because of this conflict? Do we have this conflict remain something that is only about Ukraine or does it spread further? And so because we do not know the trajectory of this crisis, we don't know where the ceiling is for oil prices. One thing that we would say is that there's always this view that when you reach this price,

you're going to have demand destruction. And clearly we saw demand destruction in 2008. But remember in 2008, when we saw demand destruction, oil prices were approaching $150. And so I don't think we can be sanguine that demand destruction is coming in the next $5 or $10. So I think this oil price has room to run. And I don't think we're going to see sanctions removed or companies willing to re-engage with Russia until those troops are back in their barracks. Demand destruction. Have you heard the phrase, the cure for high oil prices is high oil prices? That refers to the fact that producers tend to ramp up production when prices are high,

but also that at exceptionally high prices, consumers will cut back on gasoline usage if they can. As Halima says, we're not there yet on prices to affect demand. So how about supply? What levers can we pull? You might have heard about a release of strategic oil reserves. Halima says that's not going to cut it. That is basically, as my colleague said, gets you through lunchtime in terms of what daily demand is for oil. Halima points to the market's reaction to the recent strategic reserve release. There wasn't much of one. OK, what about shale drillers?

Couldn't they just change their plans and grow production more than they promised their investors? Because conditions have changed dramatically. Even if companies decide that they are going to go back in the business of putting the money in the ground and ramping up output to a significant scale, it's always important to understand that shale does not sit on spare capacity. The United States is not the country you call on when you have an immediate and sizable supply disruption. The only countries that sit on installed spare capacity, what you can bring on in 30 days and keep on for 90 days is the definition of spare capacity. Those countries sit in the Middle East.

And the country that is the central banker of oil is Saudi Arabia. Hence why you've had delegations of senior U.S. officials in Saudi Arabia trying to have a conversation about resetting the bilateral relationship with Saudi Arabia. Saudi Arabia is one of the only countries, if not the only country, that can add significant volumes immediately onto this market. As Halima says, there's a big difference between oil reserves in the ground and capacity that's ready to go. To learn more about whether recent events have changed the minds of shale drillers, I reached back out to Rick at Devon Energy. I was not able to record the call when we spoke, but here's what he told me.

I asked, is there any wiggle room on that 5% production cap? And he said not only no, but also that 5% was the upper limit and that his actual production is more likely to be flat versus last year. And he talked about why. It takes three months to set up a new rig and Devin often uses something called multi-well pads, which have three to six wells and can take longer to set up. So if Rick decided now to drill more oil, it might take nine months or a year before his teams were producing the extra barrels. At the same time,

inflation and supply chain shortages have affected drilling companies too. Rick says he'd have to pay 15% to 20% more per rig now than he paid a year ago. Also, when we quote oil prices, we use futures contracts that are closest to expiration. But there are many futures contracts that expire in future months. If you plot the prices on a graph, you get a curve that tells you what's expected to happen with oil prices in the future. Right now, the curve shows that prices are expected to fall.

That's called backwardation. Some traders have started to use the term super backwardation because the implied decline is particularly steep. One reason that might be the case is that investors expect output to increase as the pandemic passes and as markets adjust to the upheaval in Russia. The upshot is that if Rick decides to add new rigs now, with oil close to $110 a barrel, he'll have to pay plenty for those rigs and he won't have the oil until maybe a year from now, when the backward-aided oil curve suggests the oil price could be closer to $85. And his investors, remember, are demanding production discipline because the entire industry was deeply depressed a year and a half ago. Now that's Rick's thinking. You might agree

or disagree. He says that private shell drillers are likely to increase production. But for companies like his that answer to shareholders, he says that to get excited about drilling, the shape of the oil curve has to change. What about some of the other factors I hear investors talking about? One of them is the rise of green investing, sometimes called ESG for its focus on environmental, social, and governance factors. Some shareholders have demanded that oil companies shift away from just growing production year after year towards thinking about new business models that include renewable energy. Have they gone too far and choked off supply? Here's Halima.

ESG has been a contributing factor in some of the reticence of investors to continue to invest in oil and gas companies. But that said, I think the biggest factor by far still is the fact that shale producers were seen as destroying a lot of capital. And so it's been in the investors who have demanded capital discipline. Yes, we can talk about ESG. Yes, we can talk about signals being sent by governments about net zero initiatives and where they see the future for fossil fuels. But when it comes down to the most limiting factor, it has been to date the views of energy investors. What about the blocked Keystone XL pipeline, which would have increased capacity from Canada, or the lack of new drilling permits in the Arctic? This is a midterm election year,

and I hear some people blaming policy decisions like these for high oil prices, and it's difficult to know how much is economics versus electioneering. I asked Halima about that. That's next after this short break. TD Direct Investing offers live support. So whether you're a newbie or a seasoned pro, you can make your investing steps count. And if you're like me and think a TFSA stands for total fund savings adventure, maybe reach out to TD Direct Investing. investing steps count. And if you're like me and think a TFSA stands for Total Fund Savings Adventure, maybe reach out to TD Direct Investing. Welcome back. We were hearing from Halima Croft at RBC. I asked whether the lack of a Keystone XL pipeline or permits for drilling

on federal lands play a role in the current oil crisis. Halima says not really. I mean, yes, one of the first things that the Biden administration did was essentially finally deep six Keystone XL, this pipeline that has been controversial for quite a long time. But oil from Canada is still coming here. It is coming by rail, but it is coming here. And what I always say is, is that Keystone XL is not an oil producing field. It is a pipeline. And yes, this was something that was a very, very big priority for Alberta and Canada, a very big priority for energy companies in Canada. And we can talk about overall what does it mean if there's a view going forward about

growing production if it's seen as not a hospitable environment to building out energy infrastructure. But the immediate situation that we're facing right now, again, is about a global demand recovery, lack of capacity in the system due to, for example, look what happened in 2020. Oil prices collapsed. Many companies withdrew or cut operational budgets. And so there is this investment gap as well. And so there are all of these other factors that we really should be looking at when we want to think about where we are in terms of prices. Again, issues like Keystone, issues about, you know, permits for

future drilling on federal lands, that all is about what's going to happen, I think, more in the future as opposed to the current crisis that we're in right now. As for how long oil prices will stay high, Halima expects shale output to grow this year, largely in the back half of the year, but not by enough to keep up with demand. She also says that many traditional oil producers appear tapped out. Among OPEC members, countries like Nigeria and Angola are struggling to keep up with their output targets. She says there are three countries beyond Saudi Arabia with spare capacity, the United Arab Emirates, Kuwait, and Iraq, but none of those are nearly as important contributors as Saudi Arabia. She also points out that consumers have more discretionary savings now than in 2008,

so if prices went well higher before demand destruction set in back then, the same could certainly happen now. And we've been talking about oil, but Halima points out that Russia is also an important producer of grains, metals, and natural gas. One last thing, and it's on the subject of natural gas. The U.S. is fortunate to not rely on Russia for gas. Europe is much more dependent. Personally, I live in the woods, and I write for Barron's Magazine,

which makes me a tree-hugging capitalist. I reduce my own fossil fuel use where I can, and I'm all for more renewable energy in the future, but I also want people to be able to affordably heat their homes and drive to work right now. Now that Germany has halted a pipeline project that would have doubled the flow of natural gas from Russia, I'm wondering what are the prospects for the U.S.

exporting more liquefied natural gas to Europe? Here's Halima. Again, I think U.S. natural gas has been this incredible story in this crisis. I mean, if you want to look at the energy diplomacy that the Biden administration engaged in, it was essentially to try to get as many cargos on the water diverted to Europe. And you can see, you know, US LNG has been moving towards Europe. You also have other producers waiving destination clauses. You have countries like South Korea and Japan freeing up cargoes. But the questions going forward is how quickly can additional infrastructure be built? That is going to take time. And we still need to see signals, I think, from Western governments

about the importance of natural gas in this energy transition. You think about the Obama administration, they really talked about the importance of natural gas for coal displacement, they really talked about the importance of natural gas for coal displacement, so to meet the Paris climate goals, and also to help wean Europe off of Russian gas. One thing that has been sort of uncertain is how much the Biden administration supports the development of U.S. natural gas, because there's some in the administration that seemingly have the view that you want to keep all fossil fuels in the ground, including natural gas. So I do think now we have seen, because of this crisis in Europe, the need for additional natural gas supplies. The question is, what is the government going to do to provide that

enabling environment? I think it's very important what we've seen from the Germans essentially saying, we are going to build new regasification facilities to take in more LNG. The question is, is the U.S. going to quickly green light more terminals to be built? Thank you, Halima and Rick, and thank all of you for listening. If you have a question you'd like to ask in the podcast, please tape it on your phone using the voice memo app and send it to jack.how, that's H-O-U-G-H, at barons.com. Jackson Cantrell is our producer. Jackson, I got an email from a listener this week who said, love the show, more banter with Jackson

would be nice. And here with my initial gloom and standard rambling, I might've given this good fellow less Jackson banter. What's on tap for the weekend? Well, I'm driving down to visit Grandma Ellie and Papa Bob out in Long Island. So I can't wait to hear more about that. Grandma Ellie is making corned beef hash. So I'm pretty excited about that. You know what?

We're out of time. Subscribe to the podcast. Write us a review on Apple and follow me on Twitter. That's at Jack Howe, H-O-U-G-H. See you next week. Is that corned beef hash breakfast or dinner? And if it's dinner, quick follow up, red wine or white? Dinner and a box of red.