The True Reason for High Oil Prices
In today’s post, I will explain to you why the high oil prices were fated to happen no matter what. How that information could become an investment idea and what is the right financial instrument for when you don’t have a good grasp of the sector you are investing in.
What do we need to know about the oil industry?
The oil industry is a complex topic, but we only need to know these 4 facts to get the gist of it:
- The oil field is an extractive industry, which means that they extract material from the ground and sell it away.
- The more they extract, the less there remains, so if they want to continue in business, they have to reinvest profits on finding new wells.
- Ultimately, oil is necessary for everyone in society, and it has no substitute.
- So when it becomes scarce, its price rises, and when it becomes abundant, its price decreases.
When is oil scarce?
For us to know if something is scarce, we should take a look at how much is being produced vs. how much it is consumed. How much is available in stock, and how much do we invest in finding new wells. Let’s see:
Production vs. consumption
Below, you can see a graph showing how The Organization of Petroleum Export Countries (OPEC) has failed to deliver their quota during 2021. If the producer countries don’t deliver their quota, that means we consume more oil than what we produce.
If we consume more than we produce, inventories should fill that gap. Let’s see.
How much is in stock?
Below you can see how the 2021 oil inventories (line in the middle) in the OECD countries fall below the 5-year minimum average.
This indicates that we are burning through our “oil savings” because the current inventory is getting lower by the time.
Are we reinvesting enough to fight high oil prices ?
Because oil is an extractive industry, it requires new exploration to find new wells so they can continue to produce. To explore new fields, we need new investments.
In the graph below you can see a comparison between the price of oil and the investment necessary (black line) to keep up production and bring prices down. The green square represents the estimated investment for 2022. At 100$/barrel we are missing twice as much the necessary investment.
This indicates that there is a lack of investment across the whole sector, that creates high oil prices
Conclusion
As we could see in the graphs above, the shortage of oil was already happening during the whole year of 2021. It is true that the War has aggravated the situation, but this has started long before. The fundamental cause is the lack of investment across the sector. This makes oil become scarce, and because everyone needs it, prices rise.
On a different note, with a small amount of information, we can formulate an investment idea. Unless we produce much more oil in a short time or we dramatically reduce its consumption, we can forecast that oil prices will continue growing. If oil prices go higher, we can also assume that oil stock companies’ prices will go higher as well.
But where can we invest if we don’t know the industry well?
This is reflected with the Oil services ETF (Vaneck OIH) in my public portfolio. If we don’t know a sector or an industry in detail so we can pick some specific companies. We can always buy an ETF, which contains many stocks underneath it. When buying one stock of one ETF, you are buying dozens of companies at once, so you are diversified while you get exposure to a whole sector. This is a great way to invest in some theme, where you have a certain understanding of the macro picture, but you are not skilled enough to dive into very great detail.
As usual, this is not investment advice but a way to show you my thought process so that you can get inspired. I would encourage you to do your own research, reach your own conclusions and act accordingly. Some references you can look for on Twitter are Eric Nutall and Javier Blas. In Youtube, you can listen to Rick Rule or Finding Value Finance.
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