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Today’s stock market presents a great dilemma for investors.
With valuations inflated to near all-time highs, the broader U.S. stock market (i.e. S&P 500) offers low or negative future returns:
Meanwhile, with inflation running at 40-year highs, holding cash guarantees a loss in purchasing power. The energy sector offers a lone bright spot of value, plus inflation-protection, in an otherwise overvalued and dangerous stock market.
Today, I’ll make the case for how oil could hit $100.
Let’s start by reviewing the inventory side of the equation.
Oil Inventories: From Glut to Potential Shortage
The global oil glut created in the wake of the COVID-19 outbreak has officially been erased. Today, global crude stocks sit near the bottom of their historical range. Looking ahead, the U.S. Energy Information Agency (EIA) projects global inventories will remain depressed throughout 2022:
This depleted storage situation increases the likelihood of a potential oil shortage, and price spike, in the event of a meaningful supply disruption anywhere around the globe.
It’s also important to note that the EIA’s forecast in the chart above was made in early December, when the EIA assumed a potential demand hit from the Omicron variant of the COVID-19 virus, noting:
The potential effects of the spread of this (Omicron) variant are uncertain, which introduces downside risks to the global oil consumption forecast.
With the benefit of an extra month of new data, we now know that the Omicron has failed to make a major dent in global oil demand. Meanwhile, there’s a potential upside case from Omicron.
Omicron Could Mark the Beginning of the End of COVID-19 Economic Restrictions
Historically, it’s not uncommon for viral pandemics to end from the dominance of a milder form of the virus. Specifically, you need a variant with greater transmissibility, but lower-symptom severity. Preliminary evidence indicates that Omicron could fit this bill.
First, we know that the Omicron variant is highly transmissible and has become the dominant strain in many regions, including over 95% of all U.S. COVID-19 cases. Meanwhile, without downplaying the severity to the virus, it appears that Omicron is a milder form of the COVID-19 virus. We can see this in the fact that COVID case counts have exploded to new record highs in places like the U.S., while hospitalization and fatality rates remain well below the highs.
From my understanding, the growing dominance of a milder viral strain is exactly how the Spanish Flu burned itself out. If Omicron produces such an outcome, that’s obviously a massive upside surprise for crude oil demand in 2022.
Even without this outcome, the data shows that world is increasingly learning to live with COVID-19. Economic and travel patterns are gradually returning to normal around the globe, including a robust recovery in jet travel – the key lagging sector throughout the pandemic. That’s why current estimates from major forecasting agencies, including the EIA, project new record highs in global crude demand in 2022.
Meanwhile, things look even more bullish on the supply side of the equation.
Global Oil Supply: Most Bullish Outlook in Over a Decade
The plain reality is that oil production requires capital. And capital investment into fossil fuel development has been running at dangerously low for two years running:
After more than a decade of excess oil supply, the world has grown accustomed to the risk of oversupply in the oil market. However, with oil investment falling to the lowest levels of the last decade, capital starvation is setting the stage for potential supply shocks as the key tail-risk going forward.
We can see clear evidence of capital impairment across the board, including in the U.S. shale patch. Despite oil reaching as high as $85 per barrel in 2021, U.S. production remains 1.5 million barrels per day below pre-COVID highs. This is a 180-degree inversion from the shale boom era, when $60 oil was enough to incentivize new record highs in U.S. production.
All signs indicate further shale capital restraint into 2022, based on current rig count trends and capex plans from the major American E&Ps.
Of course, the story of shale capital impairment has been well covered. The lesser talked about phenomenon is a similar investment pullback among key OPEC+ producers, like Saudi Arabia. The chart below shows the Saudi rig count sitting at the lowest levels in more than 13 years:
Meanwhile, there’s growing chatter that Russia – the world’s 3rd largest oil producer – might also be running up against its production limit, as Bloomberg recently reported:
Russia failed to boost oil output last month despite a generous ramp-up quota in its OPEC+ agreement, indicating the country has deployed all of its current available production capacity.
So even as OPEC+ remains on the output hiking path, including the recent announcement of a 400,000 barrel/day increase beginning in February, the big question remains: how much global spare capacity exists to meet record highs in demand this year and beyond?
Throw in the potential for a geopolitical disruption in a major producing region, like the current turmoil in Kazakhstan, and $100 oil could be just the beginning of the next leg higher in prices.