Presidents don’t win elections with people angry at the pumps, so it has not been deeply surprising to find a confluence of events which have worked to ensure that energy prices remain affordable to the electorate. SPR releases, record shale production and the largely unabated flow of Russian energy (despite all policy language to the contrary) has played a significant role on the supply side of the equation. So much so in fact, that supply has even managed to mitigate what most market practitioners would have ordinarily expected to be a sizeable risk premium related to volatility in the middle east.
What happens when we know who will be in the Oval office and the market is set to clear based on more sustainable factors? We think that Louis Gave paints an interesting view here in a recent podcast on energy. We encourage people to follow his work.
The transcript of the interview addresses Louis’s assessment of recent market declines in energy prices and also why he believes his long term bull case for energy remains intact.
Transcript
Tom Holland
Good day and welcome to this week’s Gavekal Research video. We’re here today with Louis-Vincent Gave to talk about energy prices. Now Louis, this is a subject of some pain at the moment for you. You’ve been a long time energy bull and in the last couple of months we’ve seen oil prices fall about 20% Brent crude down to just a shade above $70 a barrel, which is right at the bottom of the range that we’ve been looking for for the last few months. So what’s been going wrong in the energy markets?
Louis Gave
Yeah, you know things are bad when I have both a crew cut and I’m wearing a tie. That’s how bad things have been. Yeah, it’s been a brutal few months and all the more brutal since I think the last time we talked about energy on one of these Gavekal podcasts was back in early July when Anatole and I had a discussion/debate as to what political developments in the United States might mean for oil. Anatole’s view, which turned out to be on the money, was that with higher odds of a Trump presidency, now we were having this debate following Biden’s disastrous debate performance and following the assassination attempt on former President Trump when his poll numbers were sky high.
Anatole’s view at the time was look, Trump means two things. It means drill, baby, drill and so potential for a lot more supply coming on stream, which I didn’t buy and I still don’t buy for what it’s worth. I don’t think that because the US government is going to tell energy companies to drill, baby, drill, that they’re going to go ahead and do it. In fact, today, US companies are doing the reverse. Instead of looking for oil on the Texas floor, they’re looking for oil on the floor of the New York Stock Exchange. They’re taking each other over, big M&A activity. You’re seeing more consolidation and exploration.
His second point was that with Trump, the odds of an end to the war in Ukraine would increase and that with that, the risk premium on geopolitics, the geopolitical risk premium on oil would get constrained. Two months later, I’m feeling the double pain. I’m feeling the pain first, of course, of the money loss, which hurts a lot, and then the pain of having lost my debate with Anatole, which also stings. It’s been quite brutal.
Now, what went wrong? What did I underestimate? How did I mess up? I think today, if you listen to the general media, there’s two main explanations. One of them is, “Oh my God, demand is disappointing. China is this black hole. It’s all China’s fault, lack of traction on Chinese growth, etc., etc.” To be honest, I don’t buy that argument. I don’t buy it because the important numbers out of China are not that terrible. I don’t think it’s that far from what people expected or anything.
The other argument that you hear about everywhere is, “Oh, there’s all this excess supply. Saudi is underproducing by a million and a half barrels or a million barrels per day. It’s all because of the success supply. The moment Saudi starts producing again, then oil prices tank.” You could have made the very same argument two or three months ago. When you think of the global supply-demand imbalance or balance, it doesn’t feel to me as things have changed that dramatically over the past two or three months to explain a $20 move in the price of oil.
How did we get here? Perhaps politics are part of the explanation. And here there’s two different elements to it. The first is, as the odds of a Trump presidency win have increased, maybe if you’re Iran, maybe if you’re Venezuela, you fear, “Oh my God, we’re going to get a bunch of sanctions thrown on us. We’re going to sell what we can now, empty whatever storage we might have, flood the market with whatever we have while we still can because in four or five months time, that may no longer be the case.” So that’s perhaps one explanation. Venezuela and Iran running scared from a potential Trump presidency.
I think there’s another explanation that perhaps, frankly, the market has yet to fully adjust to. I think if you go back to the first Trump administration, who was in that administration? You had John Bolton, Nikki Haley, Mike Pompeo, frankly, Mike Pence, all a bunch of guys who have seldom met a war they didn’t like, pure neo-cons. Fast forward to today and who is surrounding Trump this time around? No more John Bolton, instead it’s Tulsi Gabbard. No more Mike Pompeo, instead it’s Bobby Kennedy. You know, JD Vance. Guys who often, JD Vance, Tulsi Gabbard, they don’t talk about the war. They actually went to it. As a result, they come back being far less pro-war, far more isolationist, far more, “Let’s try to avoid having wars here, there and everywhere.” So perhaps Anatole was right after all. Perhaps the geopolitical premium in oil has been squeezed.
At the same time, we still have to acknowledge a few things. The first thing is that this big collapse we’ve seen in the price of oil has occurred against a backdrop where inventories have been drawn down to practically nothing. You take the storage at Cushing, Oklahoma and it’s been absolutely crushed. It’s not at record lows but frankly it’s not far off record lows. So you’ve got that on the one hand. Storage everywhere has been absolutely decimated.
And so you’ve got this odd quandary I think in the markets where shipping rates have actually stayed pretty firm, rates for VLCCs have stayed firm. But meanwhile, storage continues to go down and you can ask yourself, “Okay, how likely is this to continue?” So bottom line today, we are at the bottom of the trading range. This has occurred in a backdrop where we’ve basically drawn down inventories to nothing.
Where do we go from here? Sure, if global growth collapses, then that’s never bullish energy. And right now, the fears are running strong that Chinese growth is disappointing, U.S. growth is rolling over, et cetera. But maybe those fears are overblown. I think Anatole wrote a great piece yesterday called “What if the Bond Market is Wrong?” The reality is if you look at a lot of the indicators, they are showing some softening, but the reality remains that most corporates are generating great cash flows. Tax receipts are at record highs and corporate spreads are super tight. Companies very much have the ability to borrow. So you add it all up and yes, you’re having a bit of a slowdown, but the economies are not absolutely not face planting.
And to some extent, the same is true in China. I know right now the bearishness on China is running super, super thick. But if you need to borrow in China today, you can, banks are happy to land and they’re lending at record low interest rates. So the economy is slowing down, but neither is face planting. So to the point you made, we are at the bottom range of where we’ve been on oil. Everybody’s waiting for bated breath for it to crack through the bottom of that range. I still take the other side. I still think we’ll look back in a few years and say “$70 oil, that was a great buying opportunity.“
Tom Holland
You talked there about looking back in a few years time. Let’s take a step back and consider the longer term outlook for oil because clearly there is a segment of the economy, a segment of the political community which wants to talk down the use of oil for environmental, for ideological reasons almost. And there is this drumbeat in the background saying that the use of oil is on a long term structural decline so you don’t want to be investing in the oil market. How do you respond to that and how do you see oil demand evolving over the next decade or so?
Louis-Vincent Gave
So look, I think that’s a fair criticism. To this I would respond, if this explains the recent downdraft in oil, then at the same time you would have expected, say, uranium prices to go up or copper prices to go up. Let’s imagine that to your point our policymakers decide to really embrace energy transition, to really shove it down our throats whether we want it or not, that we have to use solar panels, that we have to use electric cars. Well these things don’t fall out of the trees. You have to, the energy transition requires a whole ton of copper. I do think to your point that we’ve lately witnessed a very important shift in the popular zeitgeist regarding nuclear. In countries like China you are seeing a very rapid pace of not only new nuclear powers being built in China but increasingly China going around the world and telling countries such as Saudi Arabia, “Hey, we can build a nuclear plant for you. We can do it at a low cost.” But all this is well and good but again nuclear plants don’t run on air and water. They run on uranium. They also require copper, all these things.
Now what’s been fascinating in the past two months, three months, is just as oil has been crushed, copper has been crushed even more, uranium has been crushed even more than the two of them. Nickel obviously essential for all the car batteries is down 50% in the past 18 months. So the whole like, “Oh my God, energy is falling because of the energy transition,” would make more sense to me if at the same time nickel, copper and uranium were going through the roof. But this is clearly not the case. What you’ve seen in the past two months is all the cyclicals being taken to the woodshed. So you look at this and you think, “Well, that can either be because we are heading into a global recession so who wants to own copper? Who wants to own uranium? Who wants to own energy?” That’s one possible option. The other is it was linked to market positioning. Maybe people were leaning a little bit too far above their skis and there’s been a big shake-off. So you’ve gone from perhaps a little too much optimism to right now too much pessimism and amidst this pessimism is great buying opportunities.
That’s still what I believe but I’m not going to hide the fact that right now I feel like I have a lot of egg on my face and that the past three months have been especially brutal and that managing money in this environment where tech has been falling hard, where materials have been falling hard, where energy has been falling hard and where the only thing going up has been defensives, bonds and financials has been a pretty frustrating environment.
Incidentally, that could be perhaps another explanation for what’s happened on energy because one of our big arguments at Gavekal is forget bonds. Bonds no longer diversify your equity risk. The old 60/40 of yesterday is dead and buried and the new portfolio today is a portfolio where you have to replace bonds with energy. In fact, if you did that since the COVID bottoms, if you had a portfolio that was 50% XLE, the energy I-share and 50% XLK, the technology I-share and you rebalanced every day, since the COVID bottom, you’ve actually done 3X and you never had a 10% drawdown. It was super. Both energy and tech did great and they did great at different moments and typically on any given day, they had a negative correlation.
Now I think for me, one of the more important developments this summer has been the implosion in the AI bubble that basically the air is now coming out of the AI bubble even with great results and video can’t make new highs. Now what’s interesting is that the negative correlation you’ve had between tech and energy over the summer broke down and it’s now a positive correlation. Perhaps as tech starts to implode, what you’re seeing is people de-grossing their book, reducing the risk on their books, which means selling both tech and energy at the same time. The negative correlation between tech and energy is no longer there and instead we’re back to a negative correlation between tech and government bonds. So perhaps that’s one other explanation for the struggle in energy, one that has to do with portfolio positioning, de-grossing and to me that explanation actually makes a lot of sense.
Tom Holland
But in the long term, you’d remain structurally constructive on energy and energy plays?
Louis-Vincent Gave
So look, the big question, you’re right, this is the big question, Mark. If you look at the past 30 years, global demand for oil has grown by a million to a million and a half barrels per day sort of year in, year out unless you had a cataclysm like COVID or the 2008 crisis at which time energy demand did go down. But year in, year out, you’ve increased demand by a million, a million and a half barrels per day. And yes, that has been my belief that this continues not because of anything that happens in the Western world. Actually in the Western world, demand for oil has been contracting for a while. You look at Japan, you look at Europe, you’ve had no growth and even negative growth. But as countries like Indonesia, like India, most of Africa get richer, they do start using more oil. So this is of course the big question mark is whether that growth continues in emerging markets. And my assumption has been and remains, although I’m less confident of course now with the markets moving the other way, that this would be the case.
And perhaps one of the reasons I’m less confident today is simply looking at the Indian numbers. You know, today everybody’s running around saying, oh, the reason for the disappointing energy price is China, China’s disappointing, et cetera. Actually for me, when I look through the numbers, India is the most disappointing development because you look at India right now, the place is supposedly on fire. Of all the major economies in the world, it’s had the strongest GDP growth. The stock market has ripped higher, gold prices have ripped higher. Most Indians own Indian stocks and they own gold. Indian private sector gold holding is five times the amount of gold that there is in Fort Knox. So Indians are getting richer and they’ve gotten a lot richer in the past few years. India has been in a boom. With that, you would expect higher oil consumption, you would expect higher oil imports, you would expect Indians to be buying cars. And as I show in my forthcoming paper that’s going to be published pretty soon, the big disappointment here is you look at Indian car sales and they’re like super disappointing. They really haven’t grown at all in the past three, four years.
You look at Indian oil imports, which is a bit complicated because you have to net out all the oil that they’re importing and then re-exporting to Europe because of the Russian sanctions, et cetera. But you net that out and basically India’s oil imports are roughly where they stood in 2018, 2019 pre-COVID. So you look at this and you think, okay, that’s not what I was expecting. And what if what we’re seeing in India, we also see in Indonesia and in South Africa and in Brazil and in all these other emerging markets that we’re supposed to make up for the growth in oil?
Because China is probably now reaching the point where you’re no longer going to see the growth there as you get more and more electric cars, as the electricity grid keeps on improving thanks to hydro, thanks to solar panels, thanks to nuclear. So the question is, are emerging markets, to rephrase your question, to be bullish on global energy demand, you have to think that demand in emerging markets is going to stay strong. It is still my belief that this will be the case. But things like India lately seem to argue that actually the picture might be a bit different.
Tom Holland
And one last question. Looking at the supply side, as you mentioned, clearly there is spare capacity, particularly in the Gulf states of the Middle East. But in the longer run, is the world going to be able to produce the oil that the emerging markets economies demand?
Louis-Vincent Gave
So I think, look, I’ve never been a peak oil guy and I’m still not. So I’m not that worried about that. There is lots of oil in the world. The question is, is that oil accessible at a cheap price? You look at offshore today, off of Suriname, off of Namibia, there’s tons of oil, off of Brazil, off of Colombia, tons of oil. But it’s not economical to go get it at below $65, which is more or less where we are today. You look at a lot of in the U.S., you’ve seen great productivity gains. You’ve seen the U.S. move from five million barrels a day to 13.2 or 13.3 million barrels a day wherever they stand today over the past 15 years. Can the U.S. reproduce that? No. Well, maybe they get lucky and find another Permian. But given the state of exploration right now, that seems highly unlikely.
So in terms of supply, yes, Saudi Arabia probably has a spare, well, the broader Arabian Peninsula probably has a spare capacity of a million and a half barrels. And so if oil prices go high enough, that spare capacity can come back in and cap the oil price for sure over the coming few years. But yeah, five, six, seven years down the road, if really you continue to see the structural growth in demand that we’ve seen for the past 30 years of a million, a million and a half barrels per day increase year in, year out, at some point you’re going to need a higher oil price to get that oil out of the offshore in Namibia, in Brazil or wherever else. So I’m not worried that there won’t be oil, but let’s not kid ourselves that we can access cheap oil forever, because I don’t think we can.
Source: https://research.gavekal.com/content/video-beyond-the-slide-in-energy-prices/
Vernier Capital Advisors (Europe) Ltd is in no way affiliated or compensated by Gavekal Research, and this article does not constitute investment advice.