The price of oil has surged over the last year, and U.S. oil companies are making money hand over first. In theory, the high prices should stabilize as more drilling is done. But so far, the supply response has only been modest. After years in which U.S. oil companies (shale players, in particular) lit money on fire by expanding production at all costs, the industry is reluctant to invest in new production. So what will it take? On this episode, we speak with Rory Johnston, Managing Director and Market Economist at Price Street and the author of the Commodity Context newsletter, to get a better understanding of the factors moving oil prices, and what it will take to bring them down. The transcript for the episode recorded Feb. 17 has been lightly edited for clarity.
Joe Weisenthal:
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway:
And I'm Tracy Alloway.
Joe:
Tracy, you know, it’s really crazy.
Tracy:
I … Again, you're going to have to narrow that down a little bit, but what? What is really crazy?
Joe:
Do you remember that day when oil went to negative $40 a barrel?
Tracy:
Oh yeah. It feels like absolute ages ago. Because I guess it was in April, 2020 and I do remember partly because a bunch of people started tweeting at me about whether or not they should buy oil and like store it under their bed or in their basements or something.
Joe:
Oh right. I guess because you're the only person anyone knows who has ever actually acquired physical oil and for listeners who don't know, Tracy had it next to me on her desk, a bottle of oil. And apparently it wasn't good to get into the air?
Tracy:
A bottle of extremely toxic oil. So the short answer is had you bought oil in April, 2020, you probably would be doing reasonably well right now because oil prices have gone absolutely bonkers. But that said storing oil is a big hassle and I wouldn't recommend it to anyone, but yeah, it is kind of crazy how we've swung from people wanting so little oil that, you know, they're actually almost paying people to take it off their hands to now people seemingly cannot get enough of it.
Joe:
That was so insane. The more I think about it, the more crazy that time was, but exactly right. You know, there's only so much oil storage capacity and if demand just essentially goes to zero in a matter of weeks, then suddenly you might have a situation where people are paying for it. I don't think anyone like really, I don't think very many players actually were able to acquire oil that cheap. Maybe a few trades did happen. I think for most people it got to the point where they were paid to take oil, but maybe some people did anyway. It is very different today. Oil just keeps going higher and higher. We've talked to Goldman's Jeff Currie a couple of times about this idea of a commodity super cycle. And I don't know for how much longer it's gonna go, but we are definitely in an oil price boom right now.
Tracy:
Yeah. It definitely feels like it. But the weird thing is so on the one hand there is all this very, I guess, bullish action in terms of actual crude prices, a lot of people are talking about the possibility of another broader commodities super cycle. But at the same time, if you start digging into the actual term structure of crude, it seems like people are expecting these high oil prices to go away relatively quickly. So much like the transitory inflation debate, there’s the expectation that these high prices aren't going to be with us forever – that’s kind of baked into the futures curve of crude. But again, just because we've had that conversation about inflation, and whether or not it's transitory and it's certainly been more persistent than a lot of people have expected, it feels like there's just a question mark over the entire market at the moment. And it feels like it could go either way, right? We could get oil above a hundred dollars a barrel, or we could see it start to go down as higher prices incentivize more production.
Joe:
Right? The capitalist dictum of the cure for higher prices is higher prices. But so far higher prices have not cured higher prices. Even with the surging prices, we haven't seen that big of a pickup in say U.S. domestic production. It has gone up, but not like crazy. And oil companies are making a ton of money right now, some at record highs -- in this sort of sweet spot where prices are really high, but they're not competing with each other to spend. Part of the story as everyone knows, is that the sort of decade post-GFC was a huge time for U.S. shale. Companies expanding like crazy and then they, it turned out, they lit it all on fire and it didn't actually turn into profits for investors. So there's a lot of residual fear from that time probably holding back production. But this is I think one of the key macro questions of our time, what's going to happen to the price of oil. So we're going to be talking about that today.
Tracy:
Perfect. Let's do it.
Joe:
All right. I'm super excited to bring on our guest. We're going to be speaking with Rory Johnston. He is the founder of the Commodity Context newsletter, which is really great. And he's a managing director and market economist at Price Street in Toronto. Rory, thank you so much for coming on.
Rory Johnston:
Thanks so much for having me Joe and Tracy, huge fan of the show.
Joe:
These last two years,, I mean, you've been following energy markets for a while, what have they been like for you?
Rory:
Yeah, just to give a bit of background. So, you know, I have been following the markets now for the better part of a decade. Prior to my current role, I covered commodity economics in the economics department at Scotia Bank for six-ish years. And there I was essentially in charge of overseeing the price deck or the price forecast for a whole variety of commodities, everything through the commodities kind of complex -- I like to say everything from crude copper to through canola. And that was a role that I kind of held very much through the initial bust of oil markets. For most of my, you know, grad school years, the assumption was that oil prices were more or less stuck above this hundred dollars a barrel mark. They would have periodic spurts down, but it was generally this view: peak oil supply. We were running out and that was basically the oil market that I was born in.
And then when I started working in this space, everything just completely fell apart. And as you guys very accurately described in the intro, that was very much because that decade was very much the decade of shale. And you mentioned these producers more or less setting this money on fire. And, just to put that amount of money in perspective, you know, depending on the sample you're using, it's something between $300 and $500 billion dollars of upstream investment that just never made any money. Now we're in a position where a lot of these investors are both scarred from that experience and want that return. So after I left Scotia and I was honestly very much planning on kind of transitioning out of the energy space. And I think for the reason that the energy sector has lost a lot of talent is that it was just kind of really going bad for so long. But after a couple months in my new position, my phone started ringing off the hook right around the time when oil prices went negative and everyone was trying to figure out what was going on. And all of a sudden it got really, really interesting again. So I kind of got, you know, yanked back into the space. And now I've basically been on this two year roller coaster of probably the most exciting oil markets if not in entire history, at least in recent history.
Tracy:
I'm trying to think where to start because we can take this in so many different directions, but I think one thing that's going to be important for this conversation is understanding the relationship between investors and shale and you just described how much was it? $50 billion, something like that?
Joe:
No, $500.
Rory:
Between 3$00 and $500 billion depending on the sample.
Tracy:
So you just described $500 billion of capital basically being destroyed when the shale boom went bust, maybe just to start, could you talk a little bit about why that happened? Why wasn't shale able to compete effectively or why weren't investors willing to lose more money on it? You know, in 2015 I guess is when it started crumbling or when it finally crumbled.
Rory:
Yeah. I mean, so the break even price or what makes sense for this type of production through 2014, or generally 2014/2015, was generally assumed in that kind of, you know, $70-$80 barrel range. But after the collapse in oil prices we experienced at the end of 2014, that was really kind of a stress test for shale. And what you saw across the board was that those break evens dropped precipitously, in some cases as much as half. And that was just them getting much better under pressure. They had kind of learned and grown their initial stages through a period of extremely high oil prices that didn't require a ton of discipline, but then they figured out how to do it for much cheaper.
And then the challenge moved from kind of cost discipline to investment discipline and what all of these producers were incentivized to keep producing more and more because in oil markets, like in all commodity markets, every actor is kind of an atomistic price taker, right? They have no incentive to cooperate. In many cases, they're actually legally barred from cooperating with each other in order to make the system more stable. So, these producers have this challenge where they kept taking on all of this debt and all of this, you know, equity financing, and they just poured it into more and more and more and more wells. And then you’re just consistently repeatedly crashing the price of oil. And what had generally came to be thought of as you know, ‘the shale band’ -- which was this price range between $40 and $60, or maybe a bit, you know, $45 and $65 — whereby if you went above that price shale would turn on and you know, you'd get this fast ramp up of production.
And it would, you know, quash oil prices. And if it dropped below that price, shale would turn off and you would kind of get the balance. And for most of that period after 2014, right up until 2020, you got that upside acceleration, but you didn't get much of the downside turnoff. So, you know, what made shale different was that shale is what we call a short cycle type of supply, which is it's really, really quick to ramp up. And most of its production happens in the first year, year and a half. So it's a very quick decline rate versus historical types of production where it took, you know, the better part of a decade to get some of these assets like ultra-deep sea or an oil sands mine, or something like that, up and running. But then they produced pretty steadily for decades. So shale was supposed to be this quick on and off function, the economic swing producers, people like to say, and it just really didn't work out that way because no one was cooperating and everyone was just producing way too much oil.
Joe:
When did shale stop, in terms of being that swing producer because even after 2014 or 2015, I think people still talked about shale quite a bit as being as effectively putting some kind of cap on the price because of the ease with which it could be turned on. So at what point did investors say, you know what, we really just don't feel like lighting money on fire anymore?
Rory:
Yeah. I think, a lot of people have been sounding this alarm for most of that kind of half decade period. They're like, they're lighting money on fire. This isn't sustainable. Prices need to be higher. We need more discipline, etc., etc. But it really like that was gonna be something that probably played out a bit slower and more gradual. And the big thing that changed was Covid, you know, the Covid shock hit and everything just ground to a halt. And again, to put in perspective just how much of a crisis Covid was for the oil market in particular. Typically when you're talking about, you know, periods of over or undersupply, you're talking about, you know, a couple million barrels a day at the high end, like maybe 2%, 3% of global supply in terms of deficit or surplus. In Covid, you know, in that initial Covid shock, you lost upwards of 15% of demand and supply didn't turn off very quickly. So you had absolutely wild builds in inventories all across the world. And I agree with your assessment at the beginning that I don't know how many barrels really traded for those, you know, negative $40 WTI prices or what have you. But the fact that you got to that level was just evidence of how acutely stressed the entire oil market was and how you basically didn't have, you know, effective operational inventory capacity anywhere in the system left.
Tracy:
Did anyone get paid to a take on oil at that point in time?
Rory:
I'm sure there was a handful of cases. Bloomberg actually did some really good work a while back about some traders that made a lot of money on that trade. But I think as a general view, it's not, you know, thinking about that day or, you know, April 20th, I actually exclude it for most of my price series, cause it just mostly makes everything look really weird. It’s kind of an anomaly. And I think it's more evidence of how broken things were relative to it being a useful price signal.
Joe:
I think this is like the second episode in a row where it's come up, that we all have to modify our charts because they're going to look so ridiculous -- the various five-year charts that you just sort of like automatically ring up. They're just gonna destroy the y axis on so many charts. We're just gonna have to like exclude them or like put your fingers over the chart.
Rory:
Absolutely. I mean, I tweeted something like that at the very beginning of Covid It was my really selfish, initial take about what was happening through every market. I have to break all of my charts.
Joe:
So right now, okay. WTI, it's a little bit over $90, , we're recording this on February 17th. It's actually, I think it's around $92 a barrel. We’re at prices in which theoretically shale should be highly profitable. And I think there has been some pickup in production, but why don't you tell us more about what's going on in the here and now and sort of like bring us up to speed where the market is now?
Rory:
Yeah. So as you were saying, WTI’s trading in the nineties, we had the first sales of dated Brent, which is the main kind of global spot benchmark, above a hundred dollars a barrel, I think it was yesterday. Obviously the market's exceptionally tight, inventories are wildly low across all visible OECD tanks. We're back down well into the kind of inventories we saw back in that kind 2010 to 2014 period when prices were sustainably, like durably, above a hundred dollars. I think it's also important to remember, you know, everyone thinks about a hundred dollars oil as this kind of, you know, mythical benchmark. And I think this is the same with, you know, all assets across the space, but particularly in non-inflation adjusted assets. You know, 2014 a hundred dollars is more like, you know, $125 now.
So we're still down from where we were then. But I mean, this just becomes important because when people think about what is even sustainable from a demand destruction perspective, I think this is where that starts to play. But I mean, as you were saying, you know, prices are wildly high and, you know, back in 2018, when we saw what was then probably the largest burst of shale production growth, which was between one and a half and 2 million barrels a day, a year in 2018, that was with prices well, well, well below where they are today. So the question is, you know, where is shale? And we go to this question of, and I think frankly, it's the, you know, trillion dollar question in the oil market. It is the single most important forecast variable in anyone's outlooks is not just what will shale do this year, but what will shale be able to repeatedly kind of sustainably do over the next five years?
Because it's important to remember for, you know, people watching the industry that in that year, in 2018, when shale grew by one and a half, 2 million barrels a day, more or less, that overwhelmed demand growth for that year. You know, it wasn't just, you know, shale was an important piece of demand. It was an important piece of supply growth. It was really the entire ball game in many years and many other producers, OPEC, namely OPEC+, had to, you know, ratchet back supply in order to continually balance the market and it just felt like a losing game. So now, we find ourselves in this position of why isn't shale growing and there's a whole bunch of reasons for it. But the main one everyone's talking about is this idea of cash flow discipline, or really, you know, not going through that capital destructive period again.
Tracy:
So I want to get into that a, a little bit more, because this is something that came up when we were speaking with Jeff Currie as well. And I've written a little bit about it on the Odd Lots blog, but before we do, I mean, you mentioned looking at prices over the future. So how much does the backwardation that we're seeing in the curve -- you know, this idea that oil prices might be high right now, but people expect them to go lower in the future -- how much is that an impediment to shale producers turning the taps back on,
Rory:
It's an impediment to a certain degree because of the way that they typically hedge their production forward. But I think the important thing to remember about backwardation and this is something that, you know, it's a frequent talking point in Commodities Twitter, is a lot of macro folks view backwardation as a sign that, you know, the market is forecasting, that prices will fall into the future, which in a sense is true because the oil market is cyclical and high prices cure high prices. And typically that kind of falls over the other side, but really what backwardation is showing you is not so much what the expectations of the futures are, but really it's a snapshot of the current state of the market and appetite for buying crude, you know, into the future. Really what it's showing is we're extremely tight in spot markets and the signal is super high to say, you know, drain everything you have out of inventory. In the inverse system back when you know, oil hit negative prices in 2020, you had massive, super backward, super contango, which was essentially paying people $15+ a barrel to store for a very brief period of time.
The forward curve is how the oil market kind of solves that inventory, basically pays inventory one way or the other to balance the market in any given moment. So I would say that's the most important thing to think is that, you know, I always like to say, backwardation is bullish and it's because it's mostly a reflection of current supply demand balances rather than future expectations.
Joe:
Can you just give us some numbers, when we say oil is extremely tight right now, or the market's in deficit, what are we actually talking about?
Rory:
Yeah, so basically for most of 2021, or actually all of 2021, the market was basically undersupplied by something in the range of one and a half to 2 million barrels a day. So again, I think that's a lot of undersupply in this sense that that's really as high as it used to get. I think we all have to forget how wildly out of whack supply and demand got during the initial Covid shock, but for a long period of time, that's a lot of kind of insufficient supply. And inventories fell from their all time highs back down into that 2010 to 2014, you know, normal range, back when we thought oil was really scarce, and it should be above a hundred dollars a barrel then.
Tracy:
Just to get back to this question of capital discipline. So we have seen various, I guess, energy CEOs at times talk about this change in the relationship between investors and oil companies. So it used to be, you threw a lot of money at the space and you lost it. And then once the shale boom collapsed, companies started getting really focused on cutting costs, really disciplined on actually returning money to investors. But I guess the question is, has that relationship swung too far? Is it too conservative now? Is it to the point where, you know, ultimately the energy industry isn't going to be able to satisfy both the demands of, I guess the broader market and the demands of shareholders who are very, very unwilling to invest more capital for expansion purposes into these firms?
Rory:
I'm currently seeing a bit of what I'm calling like a bar belling of the shale patch, which is, you know, at the high end, you've got some of he majors that, you know, the Exxons, the Chevrons, that are looking to grow, not gangbusters growth, but they're looking to grow materially, you know, 150,000 barrels a day in the Permian between them or something like that. On the other end, you have the private players that ramped up. They're the first ones to really start ramping up. They're the first ones to kind of lean into this rally. But the general perception is that, you know, they have a less of a long term kind of quality inventory behind them. So it could be a bit more flash in the pan. The part that really isn't moving right now is that kind of middle of the barbell, which are the U.S. independents, that were very much the face and driver of the past decade of U.S. shale production.
You're talking, you know, players like EOG, Pioneer, Diamondback and Continental Resources, etc. They're all more looking in a range of kind of capping growth in that 5% range. Now, you know, it's always hard to trust the sector when they say this, because they've said these types of things before, and then they ended up overwhelming the market. Now obviously things are very different post-Covid, because everything feels at least slightly different, you know, post-Covid, but there's essentially two scenarios I see going forward because you're right that with prices this high, virtually every shale producing region in the United States is profitable. So it's a real a willingness to invest, not, you know, a project economics question at this stage now. So the two scenarios I see are basically a scenario of reasonably moderate shale growth, maybe something in the range of, you know, 300,000 to 500,000 barrels, a day growth, which just frankly, the market will need in order to balance itself.
There just aren’t that many additional sources of supply out there. So, you know, you're gonna need some. So is it going to be a little shale or is it going to be a, you know, the other scenario, a high shale growth where you could see a million barrels a day or more of production? And I think those two scenarios are going to very much shape how you think the next five years in the oil market are going to go. In the low shale environment, actually let's start with the high shale, cause I think it is probably the most likely that you're going to get some growth with prices this high. You know, reasonably strong growth what's changed. There is that shale band I talked about a little earlier -- that $40 to $60 range probably feels more like $60 to $80.
Now, I think the reason for that is that the one thing that definitely has happened is even if these producers do start investing again, I really do think they've all been mostly scared out of the kind of previous practice of dramatically outspending cash flow. So I think that will always kind of remain as a form of anchor on investment going forward. So you're not gonna get those periods of growth or you're unlikely to get those explosive periods of growth like you had before, but in that low growth, you know, low U.S. shale growth scenario, I think that's where things get especially interesting because then you're probably going to be in a situation where you have prices on a kind of a go forward basis, you know, nineties above a hundred dollars because you're gonna need to start incentivizing other forms of production globally.
Where else is supply going to come from? You've got U.S. shale, you've got OPEC, which by the end of summer basically, end of fall, you're mostly gonna have that production capacity tapped out. You're gonna have a little bit more in Saudi Arabia and the UAE, but beyond that OPEC’s more or less done at that stage in a real incremental growth sense. And then outside of OPEC in the United States, you're really looking at three main areas. You're looking at, Brazilian pre-salt, which is deep sea. But that's in an area that's been kind of a chronic area of disappointment before. You’ve got the really interesting new discoveries in Guyana. And I think that will be an area of real growth probably ramping up to about one and a half to 2 million barrels a day over the next couple years.
And then you've got Canada where the oil sands, which is again, that's my specialty is really Canadian liquids production, but that's an area that had more or less been counted out as a major contributor in the future. And now starts to look really good because you have a massive asset base, resource base in a country with, you know, you know, friendly politics at a time when things like European energy crises have us thinking about energy security again. And I do think with prices this high, you're gonna start to see more incremental growth out of Canada. So I think those are the types of areas where you're going to see possible production, but it's gonna be the outlook, or it's gonna be the trajectory of U.S. shale that is going to determine which one of the two scenarios we end up falling in.
Joe:
And there's essentially, it doesn't sound like any prospect for the sort of 2018 or pre-Covid style where it's just automatic swing production. Price goes up, you suddenly get more, because I take it these other possibilities, Brazil, Guyana, which as you described as a one to two year project out, at least the Canadian oil sands, are just not as not going to be as responsive?
Rory:
Yeah, exactly. All of those types of production are more what you would call that classic kind of traditional types of production where it's, you know, lots of lead time, lots of upfront capex, those are the types of projects that had really started fall out of favor in the oil industry because of this heightened uncertainty, because of this price volatility, people liked U.S. shale because you could more or less hedge down the curve, get your production up and going within a year or within, you know, honestly months. And then have most of that asset produced out within a year or year and a half. So that was very much the way investment was starting to go. And I think one of the things that in that low U.S. shale growth scenario we discussed, I think one of the things that you're going to start to see is investment kind of attitude and sentiment start to shift more favorably back towards those longer cycle projects. Again, just because that is frankly what most of the resource capacity or potential in the world is.
Tracy:
How much do ESG concerns factor into investor unwillingness to come in and fund this market? Because of course, this is sort of one of the ultimate ironies of everything that's been going on, and Jeff Currie touched on this as well, but we really were supposed to be moving away from oil. And presumably that was one of the reasons that, you know, shale kind of fell out of fashion. We're all supposed to switch to renewable energy sources. And certainly if you look at some of what the shale companies have said in recent years, they are very much complaining about this, but on the other hand, it has just become very, very clear over the past year or so that we are nowhere near actually weaning ourselves off of crude dependency. How big a factor is ESG in this? And then secondly, is there a way to sort of thread the needle between renewable energy and oil
Rory:
Yeah, I think, you know, just to dwell on the ESG question a second, it's obviously complicated and hard to pull apart with everything else that's going on, but broadly I think one thing that's happened is, you know, access to capital has definitely gotten more scarce, both from equity markets and bank lending, which they've started kind of pulling back from lending to the space as well. So that's definitely happened. One of the other things I think it's important to remember about, you know, the trend towards ESG kind of indexes and stuff. It was very easy when those indexes were outperforming because most traditional resources, you know, most of all the oil industry, because of all that capital structure and because of low prices, it performed really, really poorly over most of the last decade. So one of the things I'll be also interested to see is, you know, this year has been a big outperformance in last year as well of traditional energy over some of the kind of key names in the ESG portfolios, or at least outperforming, you know, versus the indexes that exclude those type of producers.
So I'll be interested to see if that trend continues at the same pace or plateaus or reverses to a degree. But I would say that generally this is in terms of an immediate cause one of the smaller ones and lots of people in the industry will disagree with me on that. But I think that, you know, that investor discipline question is really more important. It's not so much about, you know, do it cleanly, it's just do it profitably. And then the other thing that I think is happening is that you've got all of these non-equity investor capital discipline related issues that are going on, particularly in the U.S. shale patch. You guys on the Odd Lots podcast have done such a great job following all of the microeconomic kind of supply chain story through Covid and you know, the U.S. shale patch, it's not immune from that same kind of disruption.
So, you know, right now we're running into issues around labor. We had issues around pipe, you know, last year when steel was scarce. We're now running out of sand again, which is something that had been an issue a couple years ago and we mostly forgot about, so you have these other supply chain issues and at the same time going forward, you're also having these environmental questions, not on the ESG side, but more on the government regulation side, around increased seismicity and kind of earthquakes in some of these producing regions, mostly related to how they were disposing of wastewater from fracking operations, as well as fugitive methane or leaks of natural gas from these sites. All of that together, I think is going to make it harder for shale to grow in this environment. And I think it's just one extra thing that adds on to that investor or cashflow discipline narrative and why it's so hard to pull them apart, because they're really happening at the same time. And they both kind of accelerated at the same time.
Joe:
I saw that this week about the shortage of sand, can you remind me, how do they use sand again? What's the role for sand in shale?
Rory:
So basically how a shale well, how it gets to producing, so shale is different than a lot of traditional resources when people typically think of oil production, they think of, you know, drilling a hole straight down to the earth and then, you know, oil pops out like in There Will Be Blood or Beverly Hillbillies.
Joe:
Drinking your neighbor’s milkshake.
Rory:
Right. And that's mostly the traditional form of oil where that oil had seeped up from elsewhere and kind of got trapped under a big, you know, cap rock or something that you basically poked through. And then all of that pressure pushes it to the surface. In shale, you’re actually going one step backwards in the geology. You're going into the source rock. A lot of this oil is formed in these kind of sedimentary layers of geology, but then typically leaks out and goes elsewhere. What you're doing in shale is you're basically going right to that source. So you're kind of going down and instead of into a pool, you're kind of going sideways or drilling horizontally through these geological shale or sedimentary formations. So you drill down and then you finish them by, you basically pump a bunch of proprietary fluids and proppant, and that's where the sand comes in. Basically that sand acts as, you know, you basically pump it down it fractures and shatters all of these formations and the sand gets caught in those, in those cracks and holds them open. So it can allow that hydrocarbon to come out and get pumped to the surface.
Tracy:
So I know you were mentioning some alternate sources of supply, like Canadian oil sands. But there is at least one big one that we haven't spoken about yet and that's Iran and it's kind of funny how high prices, know, we said the cure for high prices is often high prices, but often high prices also seem to be the cure for, I guess political restrictions and tariffs and things like that. What are the chances that some of that oil gets freed from the Iranian market as higher oil prices become more of, I guess let's say a political pressure point for the Biden administration?
Rory:
It's interesting the way that's evolved this year, because I remember last year kind of thinking something similar and someone that had a lot of knowledge about the sanctions negotiation process kind of told me the thing you need to remember is that the people that deal with sanctions policy, aren't the ones that are worried about gas prices. So what's interesting is just how dramatic price gains have been, that that consideration has worked itself into the negotiations. And I think it's, you can never know exactly what's going on, you know, behind the closed doors, but it seems pretty clear that the high pump prices have had some accelerating effect on the negotiations and not just in Iran. You've also seen additional kind of, you know, at least steps towards loosening or allowing more Venezuelan oil production as well. So I think the way to think about Iranian production, at least right now, I think in the longer term, you could definitely have more investment and everything else.
But I think the immediate question of, you know, if sanctions dropped today, how much more oil could we get? And this is brings us to another interesting debate within the industry right now. That’s a big debate as to how much can come back. And the big question there is how much is Iran currently smuggling around sanctions that are currently in the books and the rash there is essentially the more they're smuggling around the more that oil is already getting to the market. So an easing of sanctions wouldn't give more oil. So the higher your smuggling estimate the lower your potential supply addition estimate from sanctions easing now. And I'll just pick a nice kind of center number here. We probably looking at somewhere in the ballpark of a million barrels a day of additional supply from Iran that could come on within three to six months of an easing deal.
Now, based on the current trajectory of those negotiations, it seems like the White House really wants to get this done, and potentially wants to get this done ahead of, you know, midterms later in the year. So if we saw something in some kind of deal reached in the summer, you could potentially see additional oil by year end, but probably the market would frontrun that anyways and you'd get the price response quicker. So I think it's an interesting question. It's always hard to kind of handicap the probability because it really is, if not a binary, it's at least a stepwise function, whereas all the rest of these are, you know, it's between 500,000 and a million somewhere on there based on a sensitivity function, whereas Iran it's really, you know, does it get done or doesn't it get done?
Joe:
That's really well put, you know, is there anything else, are there any other levers that the white house could possibly pull here? I mean, when, you know, shale, like obviously people rage at the administration, both in the U.S. and in Canada over prices of gasoline, but obviously there are just market forces or at least in large part that's preventing, you know, the capital is not being invested. Are there levers that you see that the white house could pull beyond anything international? Other domestic policy moves that could loosen the market?
Rory:
I mean, honestly, the only kind of suggestion that I've seen that I think would have a really, you know, noticeable and at least short term durable effect on prices would be an elimination of the gas tax. But I think this gets us back to another conversation along the kind of ESG line, which is, you know, you're kind of fighting against yourself if you do that, right? Because one of the things that people that have wanted energy transition have been arguing for a long time is that fossil fuel should be more expensive. Right? That’s part of the reason we do things like, you know, we argue for carbon taxes is that we want to, you know, internalize an externalized cost so that the market can kind of better decide what you should be doing or what kind of fuel you should be consuming.
Part of the challenge is that a lot of activists have focused on the supply side of the ledger because the demand side is really politically difficultSo it's really hard to argue for carbon taxes. They've kind of been tried and, you know, succeeded or failed to varying degrees, but there are very much of politically, you know, toxic topic. So a lot of people will just oppose pipelines instead. And I think what we're experiencing is functionally a supply side shortage, which is what you'd get, if you opposed all of the new production coming down the line. And what that does is you do inevitably probably get some kind of reduction in demand just because, you know, demand curves slope down, but the downside is that you're kind of getting that impact in the economically least efficient way.
And I think the other risk here is that, you know, even if ESG or some of these environmental policies, aren't directly to blame for the current energy crises we're seeing, a lot of people will argue they are and a lot of people will believe they are. So I think one of the challenges here as well is, it increases the risk of political black sliding on really useful and needed demand side policies when we have moments like this. And a great example is, you know, Canadian gasoline prices are at all time highs right now, despite oil being nowhere near that level. And the reason for that is twofold. One, the Canadian dollars is weaker than it used to be, you know, when oil was this high. So we're getting that currency impact. And additionally, all of these additional provincial and federal taxes and carbon taxes have been layered into the prices that most people didn't notice for the last couple years, because prices were going ever and ever lower. Now we're kind of noticing, oh wow, everything is really expensive now. And I think that kind of, you know, feeds very directly into the inflation debate. And I think, obviously, you know, Joe, you've tweeted a lot about how is it inflation or is it just gas price? And obviously, you know, of all commodities, that's the number one thing that everyone's very much aware of is what are you paying to fill your tank?
Tracy:
Wait, so just on that note, I mean, you emphasized this at the beginning of our conversation, this is the biggest variable that goes into a lot of people's models and certainly their models of inflation. So what's your sort of gut take on where oil prices are going to go, let's say this year? You knew this was coming right?
Joe:
The multi-trillion dollar question.
Rory:
Yeah. I would say that I spent most of my career as a kind of a wishy-washy, two handed bank economist. So my answer will reflect that, but I really return to that scenario outlook, which is, I think that the prices we're seeing right now are likely overbid because of some of the geopolitical issues on the stage. Obviously, you know, even today there are up and down headlines about Russia and Ukraine, the Iran stuff, etc. I think that maybe we'll come down from here, but I think that if we don't have a really noticeable and durable increase in U.S. production activity by the summer, I think that we're very clearly in a hundred dollar plus environment for a while.
I’ve called time of death repeatedly on shale before, so I'm very wary of calling it again because you know, it always seems to come back and produce more. So I think that it's likely they will produce more and will kind of end up back down into that, you know, $60, $70 to $80 range. But I think again, we just haven't seen that investment come through. The first sign and I thought this was really interesting, the prices traded higher a couple days ago. I'm trying to, it was last week because of some of the geopolitical, but it was actually the first day that we saw a really, really big jump in the U.S. rig count. It was, I think you saw 19 oil rigs and 22 overall rigs added week on week for the Baker Hughes rig count. And that was the largest week on week increase that we've seen in four years. That's the kind of thing that if repeated a couple more time before June or July, then we're in that higher growth possibility environment. And I think prices are going to start to ease back at least temporarily into that kind of, you know, you know, eighties, seventies range until that's confirmed. And then we'll kind of see where we go from there.
Tracy:
I'm getting flashbacks to 2015, 2016 and you know, waking up every day and having to look at Baker Hughes and the oil rig count, although back then it was because it was going in the opposite direction.
Joe:
Yeah, #rigcounthuesses that was like iconic Finance Twitter canon.
Tracy:
That’s right.
Rory:
It totally was. Right. And I think it's definitely fun to focus on them again. And I think part of the reason they fell out of favor is it became really hard to compare across time.
Tracy:
Oh, interesting
Rory:
Because all the rigs that they're using now are very different. They're much more productive. They're being used in more productive ways. So you have to adjust that rig count. Because if you look at the rig count, we're still way, way, way below what we would've seen in 2014. Cause you had a lot of these legacy old rigs there and what we also saw through Covid and something I've been following is similar in that kind of, you know, rig count watch in the following years, everyone started looking at these drilled but uncompleted wells, or DUCs, right? Yeah. And that's also played a lot into our outlook for the sector this year, because through most of that past half decade or so you saw a really massive mountain of these DUCs get built up because drilling continued to outpace the capacity to finish them.
And again, we go back to that where the sand is used, you drill a well, and then you complete it separately. And the reason you have DUCs is that, you know, sometimes you don't complete the wells you finish. What we've seen this year is that they've gone rapidly in the other direction. And they're basically near their lowest point on record as you know, oil producers and shale producers use that inventories as a way to subsidize their current production without to go through the effort of drilling the wells. So they just finished them all. And now we're running into a situation where we really are actually going to need to drill more wells again, which is why I think that the rig count is going to be your first indication of whether or not the U.S. shale patch is really kind of turning back up again.
Joe:
You know, we just have a little bit of time left, but something I'm curious about, we haven't talked at all about the demand side really, we’ve been talking about supply almost completely because that's where all the action is, but I really, I don't have any great sense, like okay, here in 2022, where is demand and how does it compare to say, you know, February, 2019, or even February, 2020, I guess without much Covid impact yet. Has demand boomed. And at what point does demand start, you know, demand destruction, as they say ,where the price of oil starts impeding how much people actually use?
Rory:
Yeah, I think roughly before Covid we had reached that, you know, hundred million barrel a day benchmark of global oil demand and then it fell very dramatically through Covid obviously, and we're more or less back around that level or pretty close to it now, at least through this year, it's expected that we're gonna get back there on a sustainable level or durable level again. But the important thing is there that we haven't returned to the pre-Covid trend. We’re just back up to that level. So now it's this question of, you know, how fast is the steady state growth of oil demand going forward. Before Covid, we would've expected on a good year kind of something in the ballpark of one and a half million barrels a day of growth annually on the demand side, which is why, again, that one and a half to 2 million barrels of U.S. shale growth was so, you know, unsurmountable. But now it's going forward, you know, do we return to that? And it looks like we're probably going to return to something close to that. I think one thing we've talked about a lot through Covid is, you know, this prioritization of durables demand and people kind of consuming a lot of stuff, obviously that all has a bearing on oil demand and plastics demand and everything else.
And the final thing that's really going to recover here is going to be air travel. It's like the last final piece of the puzzle for oil. And I think that, you know, eventually, this is going to end, no one knows when or exactly how, but I think that we're gonna get back to that stage it's, you know, of that million and a half barrel a day kind of normal annual growth, but then it's this question of like, how long does that last, when do we get to this idea of, you know, peak global demand? And I think that's probably somewhere in the mid 2030s where we hit peak global demand of oil, and then we have this plateau of varying steepness is on the other side, based on how quickly we can electrify and decarbonize the rest of the oil demand picture. But you know, that initial peak, I think in many ways is going to be the easy part.
Tracy:
Well, I guess it's a good thing we have an air travel episode lined up.
Joe:
Yeah, yeah.
Rory:
Right. Perfect.
Joe:
How profitable is the industry? We sort of alluded to it in the beginning. Some oil companies like Chevron, I think it's like at an all time high, they're in this sweet spot. Like how much is the industry loving this right now? And I'm thinking also just pre-great financial crisis when oil was at $150, I think it had like one of the most insane quarters of all time. Like I wanna say it made like a hundred billion. I might be misremembering that, but it had some like insane quarter and now oil companies, they're almost nothing to the stock market. Like at least the S&P 500, even with the big bounce back that they've seen over the last year and a half. It feels like the industry is this fraction of itself. How much is this industry making and could it, I don't know, return to its former glory days from a sort of profitability perspective?
Rory:
I think from a profitability perspective, it's not even returned to its former glory days, I think we're already at a stage where we're exceeding those glory days, because the thing that it's important to remember back in that kind of previous heady, a hundred dollars plus period of kinda like 2010 to 2014 was inflation in the sector through costs was immense. People were spending so much money trying to tap into areas of new production that really all the money they were getting in was going right back out the door. What we're seeing right now, you know, as a sector you're seeing some of the highest overall profitability across everything, back to the high points of 2008. And I think it looks less choppy on the chart too. And I think if, you know, it looks just like it's more stable if we don't get another kind of bust and U.S. shale doesn't bury the market again, I think you could have a very long period of really, really strong earnings.
And I think it's this question of when will the market start to reward growth again, that's probably gonna come at different times between different areas of producers. Maybe, you know, you're gonna start to see more prioritization of growth with some of the majors, you know, your Exxons and Chevrons, because they're the ones that used to have, or they're the ones that are best known for the expertise in those big mega kind of complicated projects like ultra deep sea. If we get back into an area where that is in vogue, I think that's where you'd start to see the growth. But I think this interesting question of, you know, when will equity markets begin rewarding U.S. independents again, to grow? I think that will be your big sign one way or the other, whether or not we're in that high or low U.S. shale growth market.
And the challenge here is, we can talk about OPEC production through the strategic lens. It's really hard to do the same with U.S shale because it's, you know, there's a bunch of producers I was saying earlier that are in many cases legally prevented from ever really coordinating with each other. So it's gonna be, you know, the trigger is going to be one producer, you know, grows a lot in a quarter and their stock price pops because of it. Then everyone's gonna chase the same thing down. At this stage, it's mostly a prioritization of that cash flow. And as long as that's happening, I think those U.S. intermediates or U.S. independents story are going to kind of keep in this level kind of 5% growth. But I think again, that is the single biggest question in the oil market and will determine how the next five years are gonna look
Joe:
Before we go, I exaggerated a little bit, I'm looking at February, 2008, Exxon had a quarter $12 billion in a quarter and a $40 billion annual profit on $404 billion in sales. So pretty enormous . Rory Johnston, that was fantastic. I learned so much. I feel like I actually have some sort of understanding of the oil market after talking to you. So thank you so much for coming on Odd Lots!
Rory:
Thank you so much for having me guys.
Joe:
Yeah, that was fantastic, Rory. Thank you.
Tracy:
Yeah, that was fun. Thanks so much!
Joe:
Tracy. I learned a lot from talking to Rory just now. He was great.
Tracy:
Yeah, he was really good. I'm looking forward to going back to the days of rig count guesses becoming important. But I did think, I mean, this is something that is often underplayed, but the role of technology in oil production and there has been this sort of technological revolution in the form of shale, but there's also been even more boring things that have happened with oil majors, just like standardizing the types of nuts and bolts that they use to drill. And that brings down costs quite a lot. And so the idea that even if you look at the rig count and you can see, it basically looks like three mountains at the moment. So there's a big mountain between 2008 and 2015, and then like another one shortly after that. And now there's a very, very small one that's building as oil prices increased. But the idea that even if the rig count itself doesn't get back to where it was in, you know, say 2012 or 2013 that you could still have a lot of oil flowing from those shale producers, that's something I hadn't really considered.
Joe:
Yeah. I hadn't thought about that either as part of the explanation for why the pure rig count numbers aren't as focused, but we're gonna start focusing on them again now because at least like the movement during a period of change is of course still going to be significant. You know, I'm just fascinated like, well, first of all, that last comment he's like, okay, what is gonna get us to that high shale equilibrium? And I, you know, as he put it, someone's stock has to surge because they had a big quarter, and then the other companies are gonna chase it. And I know we, again, we talked about this with Jeff Currie and of course I think the CEO of Pioneer made comments -- the stock market is really important, it turns out, in terms of the signal to managers, because you know, you get paid in stock. And so who the market is rewarding at any given time, from a stock perspective, that's the strategy that companies are gonna chase. And so we're not gonna kick into this higher production equilibrium until it's clear that that’s what stock investors wanna see.
Tracy:
Well, totally. And the other thing that, that it reminded me of was the conversations that we've had with Stinson Dean talking about the sawmills, right? And the difficulty that the sawmills have in actually adjusting capacity and responding to changes in demand. And it kind of feels like we're getting a semblance of this in U.S. shale. So shale kept drilling for far too long, you know, in the sort of mid two thousands or teens, investors got massively punished because of that and lost a lot of money. And now as oil prices increase, you see people sort of dragging their or feet unwilling to risk basically jeopardizing their relationship with investors once again, in order to increase production.
Joe:
Yeah. It's a great point. So much of what we're seeing now from a price and inflation commodity search standpoint is on some level like the payback for the post-GFC period, like all these decisions made then, scarring things right now. There are so many interesting aspects of that. Maybe we should, you know, also the fact that we have a sand shortage and that's contributing to the difficulty of ramping up production in the shale patch. Super interesting. I thought that was great.
Tracy:
It does amaze me that every episode basically uncovers another supply chain shortage or pressure of one type or another.
Joe:
Maybe we should talk about the sand shortage at some point if it persists because that's a good one.
Tracy:
Okay. Yeah. All right. Shall we leave it there?
Joe:
Let's leave it there.
You can follow Rory Johnston on Twitter at @Rory_Johnston.