The New Oil Balance

Lower oil prices and much reduced capex will guarantee that oil from fracking will start decreasing this year and that the supply of traditional oil will be less than it would have been. Indeed, at recent prices very few, if any, new drilling programs will be started, and a mere three years later at current prices, 80% or so of Bakken production would be history. But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term – people will not be leaping into their cars to celebrate lower gas prices. But with time they may drive an extra 1-2% percent here and elsewhere and the excess will slowly clear: possibly by mid-year and almost certainly by the end of next year. After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of U.S. fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This is a sensitive and, I believe, unknowable equation as to precise timing, but this phase will likely end only when fracking production, even at much higher prices, tops out, as it most likely will in the next five years. After that, I believe the equation will revert to the relatively more stable and more knowable one of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be over $100 a barrel. (In the interest of full disclosure I personally have been and will continue to be a moderate buyer of oil futures six to eight years out, for reasons that should be clear from the above. It should also be clear that such a bet can lose easily enough.)

David Fuller's view

Here is the GMO Quarterly Letter.

I have long held Jeremy Grantham in high regard.  Therefore, when feeling a temptation to disagree with him, my survival instinct tells me to lie down until I can think of something else to write about.

However, to widen the discussion and give subscribers more to think about, I will throw caution to the wind.  There are two important points in Jeremy Grantham’s paragraph above, with which I disagree:

1) He believes that US fracking production, even at much higher global oil prices, would most likely top out in the next five years.  No one knows for certain, of course, as this is a fledgling technology relative to most conventional oil production.  However, he must be assuming that only a small portion of oil in known shale deposits can be commercially recovered.  Twenty years ago, 2014’s US shale oil production would have been regarded as a pipe dream.  Moreover, natural gas from most conventional oil wells at that time was flared off.  The march of technology in search of profits is relentless.  The one certainty is that fracking technology will become more rather than less efficient in the years ahead. 

2) My second point is due to an absence in not only the paragraph above but also Jeremy Grantham’s entire article.  He has only mentioned US shale production, but this is not the only such cornucopia.  We know from global survey maps, several of which this service has posted over the last five years, that significant deposits of shale oil are spread across the globe.  In fact, China is supposed to have more shale deposits than the US, although not the same fresh water resources required for extraction.  We now know that the UK has far more shale deposits than known remaining North Sea oil reserves.  Inevitably, every rocky formation is somewhat different from most others.  However, the deterrent to producing much more shale oil has so far been due to political / environmental objections, and a lack of fracking knowhow.  These factors, although challenging, are also subject to change, particularly in the event of higher oil prices.

In conclusion, I question whether the price of crude oil can rise above $100 a barrel, in real terms, beyond the possibility of a brief blip caused by a temporary supply bottleneck.  However, if Jeremy Grantham is right, and he is “a moderate buyer of oil futures six to eight years out”, then oil major Autonomies should be among the better investment buys today.  In a similar disclosure which subscribers may recall, Royal Dutch Shell B is my third largest personal investment position.  I have held it for several years, often nibbling on weakness, and have confessed to being nervous about it in recent months.  However, the dividend yield of over 5% does not appear to be under threat, at least not yet, so I am still being paid to remain patient. 

Lastly, Ben Inker’s introductory article in GMO’s Quarter Letter: Ditch the Good, Buy the Bad and the Ugly, is certainly educational and I commend it to you.