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Alex Kimani

Alex Kimani

Alex Kimani is a veteran finance writer, investor, engineer and researcher for Safehaven.com. 

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The Oil & Gas Inflation Trap That No One Wants To Talk About

President Joe Biden has lately sought to soothe fears that rising inflation could hurt the U.S. recovery and undermine his $4-trillion spending plans. This comes after U.S. inflation for the month of June accelerated to the fastest clip since 2008, as the economy continues to recover following the Covid-19 related lockdowns. According to the Labor Department, the consumer price index (CPI) climbed 5.4% Y/Y in the month of June. That's about twice the average rate over the past decade. Biden has something else to worry about: Rising oil prices.

The administration will feel a little jittery about high oil and gasoline prices because of the risk they pose to Democrats' future political ambitions. It's a well-known fact that gas prices have an outsized impact on the consumer psyche. Gas prices currently sit at $3.18 per gallon nationally, a full dollar higher than prices last year.

Indeed, this is not lost on Republicans, who have seized the moment and blame Biden for rising gas prices.

Investors should, however, worry about rising oil prices not only because of the role that oil has historically played in dictating inflation trends but also because Wall Street is no longer enthusiastic about oil and gas stocks--which could, ironically, lead to even higher inflation.

Related: Uganda’s Oil Boom Is Only Just Beginning Oil prices and inflation are connected in a cause-and-effect relationship. As oil prices climb, inflation tends to follow in the same direction higher. On the other hand, inflation tends to fall in tandem with falling oil prices. That's the case because oil is a major input in the economy, and if input costs rise, so should the cost of end products.

Falling Oil Investments

Though less frequently discussed seriously compared to Peak Oil Demand, Peak Oil Supply remains a distinct possibility over the next couple of years, mainly due to serious underinvestments in oil and gas.

In the past, supply-side "peak oil" theories mostly turned out to be wrong mainly because their proponents invariably underestimated the enormity of yet-to-be-discovered resources. In more recent years, demand-side "peak oil" theory has always managed to overestimate the ability of renewable energy sources and electric vehicles to displace fossil fuels. 

Then, of course, few could have foretold the explosive growth of U.S. shale that added 13 million barrels per day to global supply from just 1-2 million b/d in the space of just a decade.

It's ironic that the shale crisis is likely to be responsible for triggering Peak Oil Supply.

In an excellent op/ed, vice chairman of IHS Markit Dan Yergin observes that it's almost inevitable that shale output will go in reverse and decline thanks to drastic cutbacks in investment and only later recover at a slow pace. Shale oil wells decline at an exceptionally fast clip and therefore require constant drilling to replenish the lost supply. 

Indeed, Norway-based energy consultancy Rystad Energy recently warned that Big Oil could see its proven reserves run out in less than 15 years, thanks to produced volumes not being fully replaced with new discoveries.

According to Rystad, proven oil and gas reserves by the so-called Big Oil companies, namely ExxonMobil, BP Plc. (NYSE:BP), Shell (NYSE:RDS.A), Chevron (NYSE:CVX), Total (NYSE:TOT), and Eni S.p.A (NYSE:E) are all falling, as produced volumes are not being fully replaced with new discoveries.

Source: Oil and Gas Journal

Last year alone, massive impairment charges saw Big Oil's proven reserves drop by 13 billion boe, good for ~15% of its stock levels in the ground, last year. Rystad now says that the remaining reserves are set to run out in less than 15 years unless Big Oil makes more commercial discoveries quickly.

The main culprit: Rapidly shrinking exploration investments.

Global oil and gas companies cut their capex by a staggering 34% in 2020 in response to shrinking demand and investors growing weary of persistently poor returns by the sector.

The trend shows no signs of moderating: First quarter discoveries totaled 1.2 billion boe, the lowest in 7 years with successful wildcats only yielding modest-sized finds as per Rystad.

Related: Why Are Environmentalists Angry About Biden’s Infrastructure Bill?

ExxonMobil, whose proven reserves shrank by 7 billion boe in 2020, or 30%, from 2019 levels, was the worst hit after major reductions in Canadian oil sands and US shale gas properties. 

Shell, meanwhile, saw its proven reserves fall by 20% to 9 billion boe last year; Chevron lost 2 billion boe of proven reserves due to impairment charges while BP lost 1 boe. Only Total and Eni have avoided reductions in proven reserves over the past decade.

Yet, policy changes by Biden's administration, as well as fever-pitch climate activism, are likely to make it really hard for Big Oil to go back to its trigger-happy drilling days, meaning U.S. shale could really struggle to return to its halcyon days.

Clark Williams-Derry, energy finance analyst at the Institute for Energy Economics and Financial Analysis (IEEFA) has warned that there's a "tremendous degree" of investor skepticism regarding the business models of oil and gas firms, thanks to the deepening climate crisis and the urgent need to pivot away from fossil fuels. Indeed, Williams-Derry says the market kind of likes it when oil companies shrink and aren't going all out into new production but instead use the extra cash generated from improved commodity prices to pay down debt and reward investors.

Unfortunately, this trend is very likely to lead to a major oil supply squeeze down the line, high oil prices, and high inflation.

By Alex Kimani for Oilprice.com

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  • Mamdouh Salameh on August 13 2021 said:
    The key is to keep global oil prices stable at such level as to satisfy global oil producers’ needs without prejudicing the global economy. A stability of oil prices comes when global oil supply and demand are balanced. This means investing regularly in expanding oil production capacity.

    However, a small rise in inflation will still be expected in a growing economy not only because of oil price volatility but also because of the so many ingredients that make up the global economy. Such inflation is normally dealt with by fiscal and economic measures unless it is left to mushroom by lack of action on the part of central banks or as a result of a destructive event like the pandemic with central banks resorting to quantitative easing (QE) to prevent the economy from collapse. We have seen this during the pandemic and also during the financial crisis of 2008/9.

    US presidents don’t like to see gasoline prices rise because this compromises their future political ambitions, hence President Biden’s call to OPEC+ to increase production.

    Both the pandemic and excessive pressure by environmental activists and divestment campaigners on the global oil industry to divest of its oil and gas assets have been undermining investments in oil and gas. This could lead to a supply deficit in 2022/23 causing oil prices to rise and leading to higher inflation.

    Moreover, the oil reserves of international oil companies (IOCs) are declining fast and they can’t replace what they are producing as a result of rising resource nationalism. Remaining reserves of top IOCs such as Total, BP, Shell, Chevron, ENI and ExxonMobil are expected to last 8.0-10.5 years.

    Environmental activists and divestment campaigners in their vehemence against oil and gas or in their ignorance don’t realize the ultimate damage they will inflict on the global economy. As a result, the Arab Gulf producers, Russia and Venezuela will be the ultimate suppliers of oil to the world at prices that suit their economies.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • JR Hill on August 13 2021 said:
    Good article. I have been dubious about fracking for some time. Not because of pipelines and boom/bust cycles but because of ground water and the uncontrolled release of gases. Gosh, when I see stuff getting burned off it irks me. Yes, its been going on forever. But times are different. Not only due to the obvious waste but that it is adding insult to injury, environmentally. Yes, I know capturing is not worthwhile otherwise it would happen. Add to that the release of the methane that can't be captured. So much more could be added to this diatribe.

    For the record, I love the smell of racing fuel in the morning. I love the smell of that exhaust even more. I love cutting mature trees for wood products with my Woodmizer and building things. But I hate seeing my forest land slowly dying or getting burned or a risk of being so. I hate that my well water level is getting lower. We live off grid with no utilities - we supply our own. 100g of propane goes 2 years. We absolutely care for our assets *actively* and live with many modern conveniences.

    But people are just plain wasteful. Are you?

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