Eric Nuttall: The world has plunged into a deep and long-lasting energy crisis that may threaten the economy for years to come.

Long before Russian tanks rolled into Ukraine, the oil and gas industry had culminated in a depleted market.

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For too long, the oil and gas industry has been vilified by those who ignore its critical role in supplying a product absolutely essential to our way of life. Having endured an eight-year bear market that saw several price collapses due first to the rise of shale hypergrowth in the United States, and then to a pandemic-induced demand shock of epic proportions, the industry’s willingness to take long-term risks. dated investment in new productive capacity has plummeted.

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Investment in oil projects peaked in 2014 and is now at only half that level even though the price of oil has since fully recovered. This investment risk aversion, combined with increased environmental, social and governance (ESG) investment, numerous divestment initiatives, restricted access to bank loans, and combative energy policy decisions such as the passage of Bill C -69 in Canada and the end of the Keystone XL pipeline in the US have served to perpetuate chronic underinvestment in new projects, resulting in structural barriers to oil production growth.

Furthermore, given still depressed trading multiples, with the average Canadian energy stock trading at just 2.6x its enterprise value for cash flow at US$100 WTI, a significant discount to historical averages of close to 7x As well as trading at a fraction of reserve values, global energy investors are insisting that excess free cash flow be put toward share buybacks rather than growth.

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Given all this, it’s easy to understand the hesitation of companies to suddenly expand capex, especially given that the request to do so comes from the same people who just a few years ago tweeted that oil executives should be jailed because of climate crimes or , more recently, have threatened the industry with windfall taxes.

Crude oil storage tanks at the Cushing Oil Hub in Oklahoma, USA.
Crude oil storage tanks at the Cushing Oil Hub in Oklahoma, USA. Photo by REUTERS/Nick Oxford/File photo/File photo

But prospects for significant oil production growth are challenged by a lack of short-cycle supply, particularly US shale, and chronic underinvestment in long-cycle supply. Even with a US-Iran nuclear deal potentially unlocking 700,000 barrels a day of production in the next quarter and relaxing Venezuelan sanctions to unlock up to 500,000 barrels a day, the oil market would still be in deficit.

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Combine this reality with the potential loss now of up to three million barrels a day from Russian exports, and the magnitude of the oil supply crisis is beginning to become clear.

Since the beginning of 2021, global oil inventories have fallen by nearly 350 million barrels from normal levels, according to research firm Kpler Holding SA. Using the 2017-2019 average as a proxy, a surplus of 290 million barrels in early 2021 has turned into a deficit of 112 million barrels.

Looking at Organization for Economic Co-operation and Development (OECD) inventory levels, a metric more used by the mainstream, inventory levels are now in material shortfall compared to levels last seen between 2010 and 2014, a time when WTI averaged around US$100 a barrel, and have fallen from their peak levels in July 2020 by an incredible 600 million barrels, representing the biggest crash in history.

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What makes the current environment substantially more bullish than it was in 2010-2014 is that current demand is about 10 million barrels a day higher, according to the Organization of the Petroleum Exporting Countries. (OPEC) is about to run out of its spare capacity, and we have spent eight years without sufficient investment in new productive capacity by the super-larges.

A woman walks past the OPEC headquarters in Vienna.
A woman walks past the OPEC headquarters in Vienna. Photo by REUTERS/Heinz-Peter Bader/File photo

There is no perfect historical playbook for answering how high the price of oil can go, as periods of negative demand growth are rare, such as the 1970s oil shock or the 2009 financial crisis. , current oil intensity per unit of gross domestic product (GDP) has fallen about 75 percent since the 1970s, meaning we would need a much higher oil price than then to match the same level of destruction of the demand.

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Historically, when the burden of oil on the world economy has reached five or six percent of GDP for a sustained period, the cost becomes too high and consequently demand falls. Demand will grow for at least another 10 years, but supply cannot keep pace due to structural challenges, so the oil price must act as a demand destruction mechanism where consumer behaviors such as carrying fly the family to Disneyland or rent an RV during the summer. Vacations become unaffordable for the masses.

Mike Rothman of Cornerstone Analytics Inc. believes this price level sits at around $183 a barrel and, more importantly, would have to stay at that level for a year to spark behavior change. This price level compares with the historical high price of oil adjusted for inflation of US$187. He also believes that the fair value of oil is US$114 given current inventory levels, meaning there is currently no political risk premium in the price of oil. This is an important distinction to make, as many might mistakenly believe that high oil prices are the result of political tensions rather than a structural bull market.

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The Russian invasion of Ukraine is likely to have a lasting impact on its oil industry, and this greatly impacts the global oil market given that country’s status as the second largest country in the world.largest oil exporter. Having potentially reached near-peak production levels, the output decline is likely to accelerate as the world’s three largest oilfield services companies have suspended operations in the country, while many super-majors have left and made multi-million dollar write-downs, they are unlikely to return for the foreseeable future.

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With OPEC’s spare capacity approaching zero in the coming months, Russia’s output loss is simply irreplaceable, arguing for a “security of supply” premium in future oil prices.

Despite the strong year-to-date performance, energy stocks remain deeply underpriced and offer a stellar way to insulate a portfolio from the inflationary risk of current and potentially record oil prices. At $100 WTI, the average Canadian energy stock could be taken private and debt-free with only 3.5 years of free cash flow, and yet still trade at a fraction of historical levels. Given that the sector will be largely debt-free by mid-2023, the prospect of significant share buybacks and dividends makes current valuations extremely attractive.

Eric Nuttall is a Partner and Senior Portfolio Manager at Ninepoint Partners LP.


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