The Energy Sector By: Gabriel PotterMBA, AIFA®

What powers the modern economy? Oil.

What is the most universal cost for a business? We could make a good argument labor costs are the most basic expense for any business. After that, I think we could make an equally compelling argument energy is a nearly universal expense. In our early history, we generally relied on muscle power—human or animal—to get the job done. After the creation of basic tools and our earliest cooperative ventures, energy costs become fundamental at every level of a value chain. Pre-industrial cottage industries and post-industrial revolution energy sources were usually some combination of wood and coal. Since the industrial revolution, these materials made it possible for energy sources to exist separately from the natural energy powered industries (water-mills, windmills). However, when we talk about the modern energy sector, we’re solidly focused on oil and natural gas. For the past 100 years, most modern machines—and by extension, modern economies—depend on petroleum products.

Alternative energy is growing in importance, but not a full replacement for oil yet

We can already hear the naysayers challenging us, “what about alternative energy sources?” Broadly speaking, our electrical grid is sophisticated, flexible, and it can accept power generation from many sources. Nuclear energy, coal plants, hydro (river & wave), wind, and solar are established alternatives to petroleum with varying degrees of importance and potential. For instance, France relies heavily on nuclear, while other European countries are expanding clean energy sources. The United States still uses coal widely. Brazil invests heavily in biofuel (sugarcane) while other ethanol solutions (notably, corn) vie for widespread adoption. The widespread proliferation of solar technology has pushed the costs for generating a kilowatt of power from solar to parity with traditional natural gas, with promise of even greater efficiencies in the future.

This is all very well and good for utility companies and the support of an electrical grid which keeps our smartphones charged and the air conditioners running. Sadly, none of these alternative energy sources is yet a fully viable candidate for replacing our oil & gasoline based infrastructure. The problem is energy density: hydrocarbons are really good at packing a lot of power in a small volume, cheaply. We have no doubt that someday, perhaps within a few decades, we can create a cheap, energy-dense, battery alternative which will utterly transform our current oil-based transportation infrastructure. For the foreseeable future, however, we’re stuck with gasoline-based cars.

Moreover, for poorer nations and their businesses, there is exactly one trump factor for deciding which energy source to use: today’s price. The environmental impact of fossil fuels is a far away cost which is debatable in scope. Worrying about global warming is a luxury only the very rich can afford. Similarly, the implications of supporting another petro-dictatorship are only going to be felt by rich, developed countries. Even though alternative energy sources are coming down in price, the widespread, continued adoption of fossil fuel powered machines suggests oil is still king.

What’s happening to oil and natural gas now?

So, we’ve established two ideas. First, oil is key to modern machinery. Second, petroleum-based machines are still the least expensive, most viable technology, which have been honed and popularized over the past 100 years. Given these two factors alone, one would think oil should become inexorably more dominant over time as it becomes more ingrained in the global economy.

However, the price of oil has recently plummeted to multi-year lows. At the time of writing this article, December 8th, the price of oil hit $63 per barrel – the lowest it’s been since mid-2009. Moreover, the forecasts from large investment banks (Morgan Stanley, Goldman Sachs, and others) suggest more struggles for the oil producers in the near and medium term, with oil prices on a secular downward trend. What happened?

Supply

If asked to explain a price-drop for a key commodity, an economics student might take a look at a classic supply-and-demand graph and ask if the supply of that commodity had increased. Generally speaking, if the supply for goods increase, you can expect the price to fall. 

Actually, if we were to look at global news over the past year, we might expect difficulty in maintaining a steady supply of oil and natural gas. For example, key energy exporter Russia threatened shutting down its natural gas supply to Europe over Ukrainian conflict sanctions. Iran still faces sanctions over its nuclear energy program, which further constrains supply. Militant Islamists in the Middle-East and North Africa threaten the existing oil infrastructure. Finally, an Ebola scare in West Africa could stifle regional trade & production.

In the final analysis, these supply-scares in the traditional oil supply regions may have bolstered existing oil prices, but these potential limitations did not compensate for the additional access to oil and natural gas across North America as a result of new technology. Hydraulic fracturing (fracking) from the Great Lakes region, through the upper plains, and down into Texas has created a glut in oil and natural gas. Oil sand refining in Canada has reached an efficient level of sophistication to become profitable during the prior decade. The previous generation’s dream of North American energy independence is reality; in fact, we’re now trying to figure out how to effectively transport excess natural gas out of the US for sale.

Certainly, the traditional consortium of oil suppliers—OPEC, Organization of the Petroleum Exporting Countries—could have restrained their output to try and increase the price of oil. The latest OPEC meeting in late November demonstrates some states within the cartel are in favor of limiting production, but there are a few more problems to limiting supply now. First, OPEC members have less combined control of global oil supply. The United States and Canada are not in OPEC and they have the ability to ramp up production if OPEC limits supply, potentially taking even more market share. Yes, there would be necessary lead time to increasing oil production which would probably boost the short-term price of oil. However, boosting the short-term supply of oil now may simply incentivize production (i.e. drilling more fracking wells) and encourage higher efficiency output techniques (i.e. using ceramic pellets instead of cheap sand for fracking). Moreover, OPEC members are not universally aligned in their goals. For instance, the OPEC cartel members each have different “break-even” prices for balancing their budgets; more specifically, Saudi Arabia can afford to keep oil cheap longer than its geopolitical rival, Iran. Given these complications, OPEC decided to maintain a high-supply, cheap oil environment, with some commentators even suggesting a “price-war” against US fracking operations.

Demand

Going back to the supply-and-demand graph, our economics student might also wonder if the price drop in oil could be explained by a lower demand. On the surface, there is no obvious reason to presume a lower demand for oil. The IMF hasn’t projected huge rates of global growth, but even uneven global growth targets of 3.3% and the assumed increase in global affluence and a developing middle class should still support increased demand for oil. 

After greater consideration, however, we must realize prices are often a reflection of market expectations for demand and supply in the future. In other words, if the expectation of global growth falls, that looks like a decrease in the projected demand. For instance, if expectations for GDP growth in China were to fall from an assumption of 8% growth to a more modest, for an emerging market country, 4% growth, we must understand the Chinese economy is still growing, but commodity prices were set with a higher expectation of growth and demand. Thus, the current lowering of growth expectations from key emerging market countries, like China, has softened the future expectations of oil demand. Moreover, the developed world continues to investigate diversified sources of alternative energy, substitutions to traditional oil (some of which we discussed earlier) while simultaneously improving its fuel efficiency standards, further curbing market demand.

Oil producers are in trouble

There are other factors which are contributing to the weakness in the price of oil. For example, US dollar strength tends to weaken commodities, which are priced in dollars. The end result is the same: traditional oil energy producers are going to be facing downward price pressure for the foreseeable future. This affects individual companies, small and large, but particularly those which depend on higher energy margins, including ceramic hydro-fracturing pellet manufacturers, wildcatting oil & gas drillers, and multinational vertically integrated oil & gas companies. Falling energy prices weaken the energy industry, already the worst performing sector this year, including both oil & gas firms and alternative energy producers. Finally, countries which rely on high energy prices, including Russia, Venezuela, Iran, and others are going to be negatively affected by the bearish trends in the industry.

"Non-financial incentives can make an employee feel like a valued player and companies can embrace these incentives to retain their top talent and affirm vital relationships with employees.”

 
Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

More about Gabriel Potter
Sign up for our Newsletter

More Articles From This Issue

Sign up for our Newsletter