13 Dec Oil-Flation (Q1-22)

Fighting in Ukraine is ongoing and increasing the chances that Europe will ratchet up energy-related sanctions and likely sustain higher oil prices. Russia is the world’s third largest oil producer and the second largest crude oil exporter. Russia stopped reporting production data after official sanctions were announced by the U.S. and U.K., making it more difficult to track output. Disruptions to oil supply from the Russian war against Ukraine appear likely to persist and will skew oil prices higher. The International Energy Agency warns Russian oil production will fall 3 million barrels per day in May, representing about 3% of global supply. An embargo of Russian oil imports by the European Union (EU), which is a low probability event because it would shut down EU’s industrial and manufacturing activity and spike volatility in energy prices, would cause oil production to fall an additional 2.5 million barrels per day. If realized, Russia has threatened to cease natural gas exports to the EU, and a recession in Europe would be inevitable. OPEC has limited spare capacity to offset lost Russian production and given constraints (including those that are ESG-induced) on capital, the U.S. has limited near-term ability to ramp up shale oil. The dearth of capex in oil and gas production over the past decade means U.S. shale production will be lower than expected. U.S. producers remain conservative in their capital allocations and even if WTI increases the incentives for drilling and completion investments are thwarted by investor demands for cash distributions.

Long term, the EU is likely to shun Russian natural gas. The EU Commission has already outlined a plan under which the flow of gas from Russia to the EU by 2023 could be cut by two thirds. The U.S. is helping by diverting cargoes of liquefied natural gas (LNG) to Europe; however, the Spring is the optimal time for natural gas utilities to store natural gas in preparation for cold months which are two seasons away and the rising overseas demand is curtailing reserves for near future needs. There is less gas in storage right now than normal, with current storage at 1.567 trillion cubic feet, or about 16% below the five-year average for supply.³

The global outrage over Russia’s invasion of Ukraine has caused oil traders and importers to abstain from buying Russian cargoes. In our maritime shipping business (WAYF), we have decided to avoid Russian cargoes and service providers from both a moral and practical standpoint. This kind of collective thinking is resulting in longer trade lanes and higher ton-mile demand, which will disrupt physical oil supply and skew oil prices to the upside.

In 2020, ARK’s CEO, Cathie Wood, predicted that oil demand “hit a secular peak” and that prices would fall to US$12 per barrel. Ms. Wood maintained her forecast in March 2022 even as oil prices hovered above US$100 per barrel, citing accelerating demand destruction. Oil prices remain elevated notwithstanding that the world’s most populous country, China, is in lockdown. Oil prices will stay volatile due to geopolitical uncertainties and investors should exercise a high degree of caution in underwriting investments based on price forecasts for oil. For now, we prefer to side with Charlie Munger who recently exclaimed “I can’t think of anything more useful than oil!” and avoid energy intensive, price-takers that cannot pass on higher costs to their customers.

[3] Source: U.S. Energy Information Administration

Article excerpted from the Q1-22 investor letter