$20 Oil?

Author: David Kotok, Post Date: September 14, 2015

One major investment house made news on Friday afternoon by lowering their forecast for the oil price to $20. Lots of arguments go into this forecast, and most of them have been repeated ad nauseam: Iran is increasing production; Saudi fears Iran and uses low price to deny Iran cash flow; fracking is still growing, so US supply is still growing; emerging markets are growing slowly, so demand is low; and natural gas is so abundant it competes with and exerts downward pressure on the price of oil. Also, geopolitical risk premia have collapsed in the global oil-pricing mechanism. Yemen, ISIL, and Russia-Ukraine are old news.

I will stop. The list could be longer, but we all know the news flow.

We don’t think the downward pressure on the oil price is over, so we are still underweight the Energy sector with the exception of selected MLPs that benefit from volume and not from price. All MLPs have been hurt in the selloff. Some have sold off to irrational extremes, so we see opportunity in the MLP space.

Let’s look at this oil price collapse from a different viewpoint. There was a large run-up in the price of oil in the 1970s. The 1973 oil embargo and the Arab-Israeli War saw the price spike from $3 to about $12 a barrel. Subsequently, the Iranian revolution, the hostage crisis, and more Middle East pressure took the price to about $30. At the time of the Iranian revolution, the forecasted price was as high as $100 when the going price was $30.

This writer remembers those turbulent days. At its peak the Energy sector was carrying a weight of nearly 25% of the US stock market. As an ironic historical note, Israel and Egypt fought bitterly in the 1973 war. Now they are both expanding large natural gas finds offshore in the Mediterranean.

So guess what happened after oil went from $3 to $30 in eight years?

Things changed. Prices collapsed. OPEC lost its power. Non-OPEC production rose. Substitutions for oil accelerated. Efficiencies rose. It took 20 years for OPEC to recover. During those two decades the inflation-adjusted price of oil returned to near its pre-Middle East war level. By the way, in today’s dollars a $20 barrel is again at that lowest of levels when inflation adjustments are applied.

As the millennium turned, we heard talk of “peak oil.” Best-selling books told the Malthusian story of the world running out of energy. And then what happened? Fracking started in earnest in 2010. In just five years it has resulted in abundance. In natural gas we now measure future supply availability by the century. We will soon see the US as an exporter of LNG.

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