Finance 101

Finance 101. Oil!

July 5, 2018


Finance 101. Oil!

Finance 101

We don’t just use it to drive. It’s in the roads we drive on. In fact, it is used in over 6,000 products that help make up modern life. Oil, that is. Black gold. Texas tea… And for a fossil fuel commodity supposedly going the way of the dinosaur, oil is looking pretty slick these days.

Oil hit $70 recently and then moderated down to a sweet spot in the mid-$60 range. But can $100 oil really be on its way down the pipeline? Spoiler alert: you might not be thinking big enough. $100 is just a number, not a cap.

For our investors, it’s not just an academic discussion. For instance, our Growth ETF Portfolio holds the Horizons S&P/TSX 60 ETF (HXT), which represents Canadian investments. The HXT holds the top 60 companies on the S&P/TSX. A significant number of them are energy producers (ie. oil companies). Oil is back. That means Canadian investors (or at the very least, investors in Canada’s oil-fuelled economy), a steady pipeline of profits is bubbling up.

Why does oil remain so important? Some call it the lifeblood of the world economy — and it’s been that way for a very, very long time.

An ancient fuel lights up our lives

The Babylonians constructed walls and towers with oil. The Chinese used bamboo drills to get at it, 800 feet under the ground. The streets of ancient Baghdad were paved with it. Marco Polo marvelled at the hundreds of shiploads of oil coming from the fields of Baku, Azerbaijan.

Today, we associate oil with images of hard-faced, sturdy workers on drilling rigs, sweating and cursing to an audience of lizards and cacti. The captains of industry who preside over small cities of infrastructure and personnel. Texas oil barons in ten-gallon hats, wheeling and dealing over territory. Saudi sheiks and Russian oligarchs. The pipelines and rail cars, moving the precious fuel to literally get the power to the people… But we’re getting ahead of ourselves.

It wasn’t until 1847 that Scottish chemist James Young made discoveries that fuelled what was to become the modern oil industry. At the site of the first modern oil well in Baku, he refined crude oil and experimented with ways to extract oil from an exhausted coal mine. By the 1850s and ’60s, inventors and entrepreneurs scrambled to locate sources of oil around the world. At first, much of the output went to literally lighting up our lives, with kerosene or oil lamps. Motorized transport and the amenities of modern life were still out of reach. But the potential was clear.

Around this time of frenetic industry and inspiration, John D. Rockefeller switched over from the produce business to oil — and put himself on a path to become the world’s richest man. By 1868, he was in possession of the largest oil refinery in the world. In 1870, working with partners, he formed the Standard Oil Company, supplying as much kerosene as America could handle (and then some. Refining capacity outstripped demand for years).

Rockefeller’s strategy would have been familiar to today’s CEOs in Silicon Valley: expand by raising new money, buying up the competition, consolidating and streamlining operations. He added his own infrastructure. He also used the size of his operations to get discounts on shipping his product to the masses.

The result? By the 1880s, 90 percent of the world’s refined oil product came out of Rockefeller’s operation, which included 20,000 domestic oil wells and required over 100,000.

However, with success, came criticism — and serious consequences. Standard Oil was pilloried by a hostile press and politicians for being a monopoly. Eventually, it would be broken up into many companies that are still operating in some form today (Chevron, Exxon Mobil, etc).

Courtesy of: Visual Capitalist

Oil greases the wheels for the rise of the modern world

America’s first energy giant pioneered a path for the oil industry worldwide. And with the invention of motorized transport, there was new demand. That came with increased urgency in exploiting oil reserves wherever they could be found. Around the globe, in the Texas oil fields, the Canadian oil sands, the Gulf states of the Middle East, Latin America, the UK’s North Sea and elsewhere, exploration continued apace. Drilling unlocked the energy potential literally millions of years in the making, to drive a century of rising prosperity.

Energy companies and investors in those energy companies had a steady pipeline to profit for decades. The promise of cheap nuclear energy that was supposed to change this situation as far back as the 1950s never materialized, significantly thanks to costly incidents like at Three Mile Island, Chernobyl and Fukushima. Renewable energy, also seen as a panacea by the latter half of the 20th century, has also struggled to find its footing until very recently. Oil has fuelled our growing modern societies and pumped steady performance into investors’ pocketbooks.

At least, that was the case until a few years ago. At that point, technological innovation and good old-fashioned greed created a sea of oil that didn’t have enough buyers.

The recent history of oil. Before the boom, the bust

If you filled up your car recently, the dog days of oil might seem like a distant memory. But it wasn’t that long ago. Thanks to a glut of supply on the world market, oil was down at $30/barrel in 2016. Fracking made it happen.

North American energy companies employed new technology to bump up energy production by exploiting fields formerly deemed uneconomical. This reduced the need for importing oil from abroad.

The world did not adjust, at least not right away. Russia and the OPEC countries are addicted to revenues from exported oil. They had few alternatives as a revenue pipeline. Therefore, these nations had continued to pump oil even as the price was clearly sliding. Soon, the world had an ocean of cheap oil on its hands.

Moving forward to the dog days of August 2017 and that glut was still choking down the price per barrel. Note the final bolded conclusion in this Bloomberg article:

When OPEC and Russia first embarked on their strategy to clear a global oil glut, it was expected to succeed within six months. It now looks like the battle could last for years.

The Organization of Petroleum Exporting Countries and its partners plan to wrap up their production cuts next spring, already nine months later than originally expected. Yet oil prices are faltering again as data from the International Energy Agency show world inventories could remain oversupplied even after the end of 2018. ESAI Energy LLC predicts that, rather than months, draining the surplus may take years.

With oil priced so low, North American energy companies struggled to keep pumping. At the height of the crash, tens of thousands of Canadians, mostly in Alberta, lost high-paying jobs. By 2017, our Prime Minister was even talking about phasing out the oil sands.

But predictions of oil’s demise were premature.

Oil slides back from the brink

The rebound in oil happened a lot quicker than the experts expected. Today, it is welling up past $70/barrel. Supply met demand.

Finally, after many false starts, in May 2017, OPEC and Russian producers agreed to cut production. At the time, commentators were pessimistic that it would have an effect in the long term (one factor: an agreement is one thing, but it’s quite another for these countries to go ahead with their pledges). But right on time, in the early months of 2018, those bloated reserves were finally depleted. The price of oil has spiked 50 percent in the past year.

The change didn’t all happen on the supply side, of course. The economy has been doing well lately and the good times look like they will keep flowing: “A strong world economy is expected to underpin solid increases in oil demand. The International Monetary Fund sees global economic growth at 3.9% in the early part of our forecast period with all regions expected to perform well.” We’ve seen inflation, a healthy job market and economic growth in general. We’re also seeing oil used for many new types of applications, like petrochemicals — or in new products, as in somewhat ironically, the manufacture of solar panels. With economies running on all cylinders around the globe, oil is essential.

As oil gushes ahead, investors are coming along for the ride

Energy stocks are up. As a result, the stock market as a whole is enjoying some better performance. This is mitigating the recent worries of earlier in the year.

And it’s not over, yet. The USA is looking to put sanctions on Iran again now that Donald Trump has canceled the nuclear deal negotiated by Barrack Obama. Oil surged to its highest level in three and a half years in the wake of the announcement. If Iran’s 2.6 million barrels of production per day are simply taken out of the equation, then $100-plus oil becomes not just a likelihood, but almost a certainty.

Of course, this latest variable of international relations does come with other risks attached. A healthy stock market is not solely determined by a healthy oil price. The Iran announcement caused volatility in other areas. And of course, if oil gets too high, there is a conundrum of diminishing returns. While energy companies will profit, companies that depend on oil for production will see profits dripping away. When oil jumps by 80%, the market as a whole gets into a danger zone that can lead to a recession. And that stock market activity doesn’t even take into consideration the pain of consumers at the pump.

That said, for now, the rise for oil seems to be helping more than it is hurting.

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