Two competing beliefs on the price of oil

What happened to the best performing index in the S&P 500 over the last month? The S&P GSCI is down over 15% and the TSX Energy Index is down more than 25%. Oil prices have fallen to near and below $100/barrel. Is this the end of the energy trade?

If you’re an investor like Warren Buffett, then the answer is no. If you’re an investor like Paul Tudor Jones then the answer is yes.

Small Supply, Big Demand

Buffett has been buying oil company Occidental Petroleum (OXY) before and since the downturn in oil. I can’t read Buffett’s mind on his decision but by gleaning his comments from this and previous investments in oil, Buffett is focusing on the increasing equity values of companies like Occidental. Buffett has said publicly that he’s betting on the price of oil.

OXY’s return on equity currently sits at about 70% and with a management that is keen to buyback shares and increase its dividend Buffett’s choice makes good sense.

What’s interesting and isn’t talked about much in the media is the shift in global oil production. The attention of the media over the last 2 years has been on Covid so it’s not surprising that the end of US hyper shale growth has passed them by. Here’s a rare interview with Peter Lynch who discusses the issue at the end of 2019.

It’s this decreased capacity that has driven oil shortages and forced prices over $100/barrel. The question of where those extra barrels of oil are going to come from isn’t easy to answer. I could get into details here but to summarize I’ll just say beyond addressing the geopolitics that hinders oil production there’s the actual time and capital required to develop oil fields.

Big Supply, Small Demand

The flip side to the argument comes from the “inflation is dead” crowd.

A little over a year ago interviews with investors like Paul Tudor Jones suggested that inflation was out of control and the fed’s opportunity to do something about it was passing. He suggested buying commodities as a hedge against inflation. Naturally, oil is/was on the list of commodities to be buying.

He wasn’t the only Wall Street pro in this trade. However, now that the federal reserve has leaned into curbing inflation the unwinding of that trade is evident in the sell off in oil. Where just a month ago oil was heading to $130/barrel, it’s presently drifting back towards $90/barrel.

Now that Wall Street has turned negative on inflation the question is whether oil demand will decrease from the current 100 million barrels/day. If that’s the case then those juicy equity values oil producers like OXY have will likely decrease as well.

So there you have it. The two competing beliefs on oil. One where there’s too much demand and not enough supply. The other where there’s very little demand and too much supply. What’s going to happen is anyone’s guess. Personally, I’m like Buffett and believe long term the supply crunch will maintain oil prices regardless of a recession.