- Jonathan Poyer
Oil: Is Inflation Obvious? Are We Sure?
Updated: May 3, 2022
I wanted to take a look at the oil markets to think about inflation. Yikes!
Mostly what got me thinking about this was a business trip to Minneapolis where I took the old, reliable Camry. From Omaha, this is a 391 mile journey or about 800 miles round trip. I had to fill up two times and decided that poor Maverick, my youngest, is on his own for college. $3.89/gallon along the way; Omaha is well below the national average and so is Iowa and Minnesota. But that is a steep expense.
How does the price of gas track the price of crude?
Looking back to 12/31/1990:
That spike in February of 2022 in the cost of gas is pretty interesting; and so is the flattening and dip afterwards. What is going on with that??? That is another topic for another day.
With the WTI in the triple digits ($99.60 at the end of April 2022), I was anticipating a surge in optimism about new drilling and accelerating production. Thus, I decided to give the Dallas Fed Energy Survey a read…exciting stuff😊.
Posted on March 23rd, 2022 the headline reads: “Oil and Gas Expansion Accelerates as Outlooks Improve Significantly”. Outstanding!!!!
· The business activity index survey reached its highest level in 6 years
· Oil production increased
· Natural gas production increased
· Equipment utilization remained elevated
· Operating margins advanced
· The index of prices received for services rose
· All labor market indices reached record highs
· The 6-month outlook improved
What also went up:
· Input costs rose
· Costs to find and develop increased
· Lease operating expenses increased
Check out this graph showing the oil and gas production along with WTI prices:
Wait just a second! What is going on at the end of that graph? What is going on with production? The March 2020 recession, highlighted with the light gray bar, shows the WTI and production shooting down. Makes sense as we shut down the economy. However, as the WTI rockets back up, production since has not done much at all. It has been two years: WTI is up, stimulus spread throughout the economy, demand moving forward. All good…but where is the production?
The Dallas Fed Energy Survey has a section titled “special questions”. Here, we start to see some of the industry insider optimism not quite matching the up, up, up the first page of the survey highlights.
We get some cool insights into what the breakeven price of oil needs to be to cover operating expenses for existing wells and also a chart showing what the breakeven price of oil needs to be to profitably build a new well. (Note: breakeven for new wells is $50-$70, dependent on the location: $56/barrel overall. Welp, we are pretty high above those levels).,
Below that information, we see what percentage of executives expect their firm’s crude oil production to change from Q4 2021 to Q4 2022. 70% of large firm respondents anticipate less than a 10% increase in production and 44% of small firms anticipate less than a 10% increase in production.
Oil prices are greater than 2X the breakeven point for new well production. The survey shows optimism. So why are these firms not increasing production or new activity?
The next chart seems to explain things in a nutshell:
That does not seem like optimism to me; at least not from investors. If inflation was really taking off and leading to high prices, would not investors be adding money into this market in anticipation of E&P? Would we not see bond investors and income seekers put their money into such an exciting growth segment of the market? Some quotes from the survey: “spending will increase with improved cash flow, but I don’t see companies raising capital and going into debt to invest in production growth”. Another quote: “shareholders and lenders continue to demand a return on capital, and until it becomes unavoidably obvious that high energy prices will sustain, there will be no exploration spending”.
These are complex markets with many, many variables in play. Surely there are exogenous and complicated factors when it comes to things like extraction and production of energy. It would be silly to make broad generalizations about single inputs amidst these complications.
That being said, here I go: Perhaps the outlook for sustained inflation is not quite what it seems. The risks do not seem worth the rewards for investors and the forecast for sustained, heightened level of prices do not seem to be there at this level of analysis.
One variable to be sure, but it seems a big one. Maybe inflation is not here to stay after all. Or……