A sneaky oil boom is getting underway

North Sea oil rig © Getty Images
The price of North Sea oil hit a two-year high

The market has a marvellous sense of comic timing.

In the last few weeks, the papers have been full of talk about how Norway’s sovereign wealth fund is looking at extricating itself from the oil sector.

Now if you ask me, that’s sensible. Your entire economy runs on oil. Why stick your savings into that mix as well? But of course, the angle in the papers has been: “Is this a sign that the fossil fuel era is over?”

Divestment, electric cars, lithium, renewable energy – it’s all the rage.

Which, of course, makes this the ideal time for the price of oil to rocket…

The oil price just keeps ticking higher

The price of Brent crude – the European oil price benchmark (the US uses WTI) – shot up yesterday to its highest level since 2015.

The latest spike in the oil price was the result of the UK’s key North Sea pipeline system, the Forties Pipeline System, being shut down for emergency repairs by privately-owned chemicals giant Ineos (its new owner).

The system “delivers almost 40% of UK North Sea oil and gas production”, notes the FT. So it’s probably not the ideal time to have it offline, what with the bitterly cold winter conditions now setting in. And it’s due to be down for several weeks.

The price of Brent crude oil jumped to a two-year high of nearly $65 a barrel. And the effect on the wholesale gas price was far more drastic – it shot up by nearly 30%.

Now clearly, this is partly a local story. The gap between Brent and WTI surged – in other words, US oil didn’t rise in price by as much. But it did rise.

And the interesting thing is that this wasn’t really supposed to happen. US shale oil was meant to be keeping a lid on things. And certainly, US production has gone up rapidly this year, jumping by more than 25%.

But what if that’s not going to continue? What if companies that skirted bankruptcy decide that they now only pump as much as the market will bear? That the marginal stuff is best left for higher prices? That they’d rather pay down their debts and enjoy a bit of breathing space?

What if they need prices to be a good bit higher than they are today before they even think of re-opening the floodgates?

As Reuters reports, US shale producers were very pleased by Opec’s recent decision to extend its production cuts to the end of 2018. At the end of the day, they’re all on the same side in some ways. If the shale giants could legally join Opec, you can bet they’d find a way to do it.

And the chairman of one of the biggest shale producers argued that “extra cash from higher prices should go to shareholders, not fresh drilling”, lest there be “another price collapse by the end of 2018.”

Dividends, not drilling. It seems the shale industry is maturing from a high-tech boom business where capital goes to die, into one where the incumbents circle the wagons, demand tougher regulations, and look to turn their treasure horde into proper profits.

That’s an interesting idea. And quite an appealing one for investors, I should imagine.  

In any case, this all comes at a good time for investors who like bargains. I mean, in this market, the idea of a bargain is highly relative – Royal Dutch Shell is trading near an all-time high, for example.

But compared to valuations pretty much everywhere else, the energy sector remains fairly inexpensive. As Jim Paulsen of Leuthold Group notes in the FT, “the sector is widely under-owned and represents a contrarian play with a positive potential catalyst from higher oil prices.”

We’ll be looking at some promising oil plays in Latin America in the next issue of MoneyWeek, out on Friday. (If you’re not already a subscriber get your first four issues free here).

The inflation danger

The other issue here, of course, is inflation. And not just inflation, but broader expectations for how high it might get.

Oil has steadily dropped down the global “worry” pile over the last 18 months or so. When the price crashed, everyone worried that US shale producers would go bankrupt. Then, when that didn’t happen, everyone relaxed and started to remember that low oil prices are pretty good news for most big consumer economies.

Since then, oil has been seen as a worry for the likes of Saudi Arabia and Russia, but not such a big deal for everyone else.

But with the price rising steadily again, that might change. Oil has a complicated impact on the economy. When the price goes up, it hurts demand – put very simply, consumers spend more money on petrol, so they don’t have as much to spend in the shops. But it also drives up costs, so it pushes inflation higher too.

As my colleague Dominic has pointed out on a couple of occasions, oil has been in a stealthy bull market. But much more of this, and it won’t be quiet any longer.

Could fear of rising prices and a belief that things will cost more tomorrow than today be enough to tip the balance towards a more inflationary economy? We’ll soon find out.

  • Guinness Asset Management

    Undeniably, RD/Shell looks good at these levels. We would expect the dividend yield to trend down from 6% towards the longer term average of about 4.5% because full cash dividends appear to be fully covered at a $55/bl Brent oil price. Add a buyback programme and there’s even more appeal – but there’s a lot more to the energy sector than just owning the Super Majors. In the down cycle and recovery phase, the Super Majors are well placed but they are likely to lag their smaller and more upstream-oriented peers as the cycle turns up (they did materially in the last cycle). We see a broader range of global integrated oil companies offering the potential for 80% dividend increases in to the end of the decade. Yes – the potential for dividend growth from the energy sector – if oil prices are maintained at around a $60/bl level. That is clear confirmation that this industry has restructured and is positioned to deliver stronger free cash flow and better returns on capital at a $60/bl level. We now just need to see if the markets are willing to pay for the recovering fundamentals…