JP Morgan has recently published a highly informative 50-page research report, “Growing Pains: The Renewable Transition in Adolescence”, (see HERE).
The report contains mountains of information and addresses topics such as the impact of rising clean energy investment, how grid decarbonisation is outpacing electrification, the long term oil demand outlook, the scramble for critical minerals, the improving economics of energy storage, and much more. In this Quick Bite, we’ll draw from the JP Morgan report on observations about the long term oil price.
As we have frequently written, the world is rapidly committing to decarbonising the energy supply. Despite this commitment and the urgency, it will probably take 20 to 30 years. This means there is lots of time to learn, research, find opportunities, and then invest.
While solar, wind, electric vehicles (EVs), and battery technologies have become key components of the transition to renewable power, coal, oil, and gas will continue to play important roles for decades. Energy analysts have a very wide range of demand forecasts – the four diverging forecasts below are from just two institutions!
Source: JP Morgan Asset Management
The oil price is presently around 40% below last year’s high, and oil stocks are trading on much lower valuations. There’s much speculation about where the oil price is headed, especially after the Organization of the Petroleum Exporting Countries Plus (OPEC+) announced its cuts to production.
While that will affect stock prices in the short term, what matters for long term investors is:
- The average oil price over a longer period of time;
- The producer’s cost of production; and
- How much oil they sell.
Forecasting oil prices is difficult and few get it right – but the following chart provides some context. This is the price of West Texas crude (black line), and the 10, 20, and 30 year averages (red, green, and blue lines respectively).
Source: Simply Wall Street
Going back 30 years, the oil price has been below the 10 and 20 average for several extended periods – but has only dipped below the 30 year average for relatively brief periods. The longer average is a far more reliable benchmark for the lower end of the range. But to my speculative eye, an entry point for investing in oil or oil-related companies starts looking attractive at around USD60 or USD65 per barrel for long term investors.
Why does this matter? Long term investors need to make sure there’s a margin of safety between a producer’s cost of production and the likely oil price over time.
For producers to deliver sustainable returns, they need to be profitable on average over time, but they need to be solvent all the time. If their cost of production is high, they need a strong enough balance sheet to cover them during the lean years.
Other considerations when analysing oil or gas companies:
- Annual production versus reserves: How many years will current reserves last?
- Capital Expenditures (Capex): Is the company reinvesting to ensure continued production?
- Diversification: Geographical diversification reduces the impact of supply chain bottlenecks.