The Real Culprit Behind Today’s High Oil Prices

Gas prices continue their upward climb, bucking oil trends. Jewel Samad/AFP/Getty Images

Commentary

Inflation is a tax. … An awful, regressive tax. Meaning, it negatively affects the poor much more than the wealthy.

Especially where energy prices are concerned. It hits those hardest who can least afford it.

And because it hits so many people so hard, folks (and politicians) tend to look to Washington for both blame and solutions. It’s the other party’s fault prices are out of control—and my party has the solution.

When it comes to energy prices, there is some liability in Washington. But for the most part it’s secondary. Policies out of the District of Columbia set the framework. They create a business environment that’s either friendly or hostile where oil production goes.

The current president certainly hasn’t been part of the friendly camp. The changes he’s made have done literally nothing to encourage the oil industry.

But—and this is true—you can’t pin the blame solely on him.

Two Big Truths About Oil

Oil (and natural gas) are commodities. And like most commodities, their prices are driven by supply and demand. But... there are two features about oil in particular that differentiate it from just about every other commodity on the planet.

The first is... it’s inelastic.

From the demand side of the equation, all hydrocarbon fuels are inelastic. There are no scalable substitutes that can be quickly swapped with the flow of oil as prices fluctuate.

Compare this to just about any other consumer good and you can see the difference. One brand of toothpaste gets too expensive... you can easily switch to another. That’s just not how it is with oil.

Supply is another factor.

It’s either on or off.

Drilling for oil or gas is an expensive proposition requiring lots of upfront cash, a fair amount of lead time, and more than just a little risk.

And once a well is drilled and in production, it basically has only two settings: zero and 100. There’s no dialing back where wells are concerned.

Pausing a well is a project in itself that essentially requires capping the well. And if that weren’t enough, restarting a well is even trickier. You’ve got to redrill back through the cap. And then there’s no guarantee that the oil flow will resume—the well could become clogged.

These characteristics of the industry make oil pretty much unlike any other commodity.

Farmers can rotate crops. Manufacturers can retool an assembly line to shift products. There’s no similar function with oil. You either produce or you don’t.

Oil is and has been a critical resource in the United States for decades. Unfortunately, it also became a lousy investment.

Wall Street Doesn’t Get It

During the first decade of the new millennium, oil prices skyrocketed. Then the industry did what almost any industry would do—it produced more.

Prices go higher... drop a boatload of cash and drill another well.

Unfortunately, the uncontrolled spending and drilling did what excess production does. It depressed prices and, for the better part of the second decade of the new millennium made oil one of the biggest losers on Wall Street.

Now at some point, the market would have stabilized itself—production would eventually slow and prices would begin to rise reflecting the change in supply. But that’s not what happened.

Wall Street injected itself into the mix.

Investors began leaning on oil producers to cut capital expenditures and refocus their finances on things that would create greater revenue for investors—buying back stock, paying down debt, increasing dividends.

And so the industry realigned with its Wall Street partners who hold all the investment dollars.

Now to be fair, it wasn’t all Wall Street. The industry wasn’t operating optimally on its own. Management had been spending so wildly during the $100 per barrel oil days that when prices fell and times got lean, most oil companies that didn’t fail were actually generating negative cash flow.

But what swings to one extreme, will usually swing back to the other. Investment in new wells is down 60 percent from 2014 and production—even at its current high levels—is still below the output in 2019.

This means the uptrend in oil prices is likely to continue—ultimately the price may go back over the $100/barrel level this year.

Rising prices in any industry lift all boats; especially in an industry that has been contracting. Oil is no different. As the price per barrel trades up through the $70s and into the $80s, the benefits of higher prices will eventually be felt across the industry. How can an investor capitalize on this rising trend? Look to the companies that will receive the most immediate impact from higher prices. And those will be companies that own and hold the oil. Expect major integrated producers like Exxon to catch a bid. But also independent explorers like ConocoPhillips should benefit as well.