High oil prices are our lot until demand is destroyed, but no peak
Goldman Sachs analyst Arjun Murti predicted the recent spike in oil prices, so it’s worth looking at his recent interview in Barron’s:
IN 2004, ARJUN N. MURTI, A TOP ENERGY ANALYST AT GOLDMAN SACHS, published a report predicting “a potentially large upward spike in crude oil, natural gas and refining margins at some point this decade.” It was a controversial call, with crude around $40 a barrel at the time. But it was right on the money.
Four years later, crude is trading around 139.
Murti sees energy in the later stages of a “super spike,” in which prices rise to a point where demand drops off. In a note last month, he wrote that “the possibility of $150-to-$200-per-barrel oil seems increasingly likely over the next six to 24 months” …
Barron’s: What do you make of Friday’s big surge in oil prices?
Murti: There have been a number of bullish fundamental data points recently that contributed to the rally. These include further declines in U.S oil inventories announced June 4, the announcement of a decline in Russian oil production in May, and recent comments that Mexico expects further meaningful declines in oil production over the rest of this year.
Longer-term, what’s driving crude to such high levels?
Spare capacity throughout the energy complex seems very limited, whether for OPEC crude oil, natural gas or refining. In all of those areas, capacity is limited. And it’s getting very difficult for companies and countries to boost supply — something that became increasingly apparent to us over the first half of this decade.
Our view started shifting, from one of “It is easy to grow supply,” which was the perceived view of the 1990s, to “It is going to be more difficult to grow supply.” That’s partly because some oil-producing regions, like Mexico and the North Sea, are declining. The Lower 48 states in the U.S. are very mature.
There are growth areas, such as Brazil and Angola. But when we add up all those pluses and minuses, non-OPEC supply looks like it is not going to grow very much.
So, essentially, there is constrained supply, along with increasing demand?
Demand has been consistently growing. On the supply side, we don’t subscribe to the peak-oil view. We don’t think the world has run out of oil.
We do think that the places that have large quantities of recoverable oil, notably Saudi Arabia, Iraq, Iran, Venezuela and Russia, aren’t on track to grow their supply aggressively. It is growing at a very moderate rate, and so the remaining oil resources are concentrated. And, to some degree, high prices are disincentivizing some of these countries to either open up their industry or spend the money themselves.
What actually is keeping them from producing more?
These countries don’t need the incremental revenue. They’re getting the revenue through price; they don’t need it through volume. It means they have sufficient capital to try and develop their oil industry on their own. With high prices, they don’t need Western capital. Venezuela, where Western companies’ assets have been expropriated, is a good example.
You’ve made the distinction in your research that while the world’s oil supply is barely growing, if at all, there is a lot of oil that’s not being taken out of the ground. Take Russia, for example. Why aren’t they producing more oil?
In a lot of the key oil-exporting countries, the government is the key driver of whether their oil fields get developed. Relative to 10 years ago, Russia is in a very healthy position.
So, logically, there is less incentive for Russia to massively grow their supply and bring down oil prices. Frankly, that’s true for a lot of these countries.
In terms of your super-spike scenario, what phase are we in?
We are getting closer to the end game here, where despite eight years of rising energy prices, supply looks like it is going to barely grow this year. We have been bullish, but we didn’t expect such a slow growth rate of supply. And demand outside the U.S., Europe and Japan has been more resilient than we expected.
What markets are you referring to?
That would include China. The Middle East is a big demand driver, though it is often underappreciated. In aggregate, Middle East demand is about the same size as China’s and it’s growing at about the same rate. Demand from Latin America is also increasing.
Let’s talk about the possibility of crude hitting $200 a barrel. If we get there, how does it play out?
Our view has been that the price will keep going up to the level where it meaningfully reduces demand. This is Economics 101; we need more supply or less demand. And because there are various political and geologic constraints on growing supply, we’re left with looking for the price at which demand is reduced. We’ve never thought we knew what that exact number is. But we’ve tried to look at the 1970s, notably the economic impact of gasoline prices that ultimately led to a reduction in demand.
How does the current situation compare with the 1970s?
In the 1970s, you had a traditional supply shock. You took a bunch of oil off the market, and the price rose very quickly in a short period of time. That led to lower demand that proved sustainable, because the market worried that the supply wouldn’t come back. It has been, up until the last three or four months, a much more gradual increase — and therefore, people have generally been able to get used to the price. And it’s allowed demand to be more resilient than even we thought it would be.
But if crude does hit $200 a barrel, what kind of prices will we see at the pump?
Oil at $150 to $200 a barrel would imply between $4 and $5.75 a gallon.
At which point you probably see a falloff in demand, right?
We are already starting to see a drop in demand in the U.S., but they are still having demand growth in the non-OECD countries, including China, the Middle East and Asia. The OECD [Organization for Economic Cooperation and Development] countries are mainly the U.S., Europe and Japan. The real question: At what point do the non-OECD economies slow down? The other thing about U.S. demand is, at what point do you have sustainable change in consumer behavior? So if the price temporarily goes to $4 [a gallon], but immediately falls back to $3, it’s likely that people will keep driving cars with poor gasoline mileage. But if people believe the increase in oil prices is more sustainable, they might shift to taking mass transportation, if available, driving hybrids or taking the other kind of actions that are necessary to reduce demand on a sustained basis.
Do you see a sustained drop in demand at $200 a barrel?
That is the big question. We have always assumed that, at some point, you get a sustained drop in demand. Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number. The questions are: How long do prices stay high? How sharply do they rise? And do people truly change their behavior or are they just temporarily driving less? It’s an unknown at this point.
I agree with much of this, especially the near-term price forecast and the statement “the price will keep going up to the level where it meaningfully reduces demand.” But I do think we are getting near the peak of conventional oil and that unconventional oil resources will not come on fast enough — either because of underinvestment or climate concerns or both.
I don’t see how crude oil falls back to $75 or less in 2028 — unless we truly began the WWII-scale effort needed to avert climate catastrophe — and would be happy to take a bet with anybody on that, though I can’t imagine anybody, including Murti, taking that bet.