TIP044-oil-101-morgan-downey

Executive Summary

 

This article provides an overview of Preston and Stig’s interview with the author of the book “Oil 101” Morgan Downey. Get ready to have the nuts and bolts of the oil industry broken down.
This article and podcast answers the following questions:

  • Who is Morgan Downey and what can we learn from his book “Oil 101”?
  • Will oil be replaced in the future?
  • Will the price of oil increase over the long term?
  • Ask The Investors: Should I invest in an inverse S&P500 in an overheated market?

Who is Morgan Downey and what can we learn from his book “Oil 101”?

Morgan Downey is an oil trader and a top authority in the oil industry. Originally published with 1800 pages, this is the book he said he would like to have read himself. This comprehensive book took Morgan 3 years to edit and filter it to 363 pages it is today. It takes the reader through the fundamentals of the oil industry from the composition of the molecular level, through the fundamental economics, and ends with how to practically trade and manage oil risk.

Will Oil be replaced in the future?

In more than 150 years since the oil industry was established, the consumption of oil has literally gone up every single year with the exception of 1973,1981,1982,1983, and 2009. According to Morgan, the consumption of oil is fairly easy to predict. It’s closely correlated with the growth in population and the economy. The overall consumption of energy is undoubtedly going to increase. You would have a hard time finding anyone who disagrees with that. Rather the battle right now is whether if the rise in energy consumption should be filled by oil, renewable energy, or even a third source.

Oil is really in a bucket for itself. What that means is that oil has properties that you can’t find with other types of energy sources. For instance, you can’t have a container’s ship sail on electricity. Another thing is that the debate about electricity, which is just one form of energy, is completely misplaced. Oil is not a big contributor to electricity – it’s simply too expensive to be used for that. When you hear about electricity being produced increasingly from windmills and solar to replace other energy sources, it doesn’t dilute the need for oil in any way. Alternative sources are typically replacing coal or nuclear and not oil. Contrarily, one of the most important features of oil is that you can store a vast amount of energy in a simple barrel and transport that very easily.

Another interesting point that Morgan Downey mentions is that while we have become more efficient with oil, this effect has not been reflected in a decline in consumption historically. He mentions cars as an example. You can now drive longer on a gallon of gasoline in the same type of car, but the cost saving has rather been reflected in more people driving SUVs, which dilutes the efficiency of oil consumption.

Will the price of oil increase over the long term?

The short answer is yes. The long answer is “yes in the very long term because…” The thing to understand about the oil business is actually very basic. There is a demand side that is consistently growing, and a supply side. The demand and supply of oil together determine the price of oil, just as in any other market. Now, where the oil market is very different is the complexity of the supply side. It’s composed of both private and state-owned companies that have huge interests in manipulating the price of oil, and they are not shy to do so. The supply side is therefore not easy to predict.

With the rise in oil demand, it can be predicted is that the overall costs of producing oil in the long run will go up, and as a result of that the price must also increase. No companies will produce at a loss in the long term and the demand will push the price to meet the long term marginal cost. As Morgan puts it, “A company will produce oil at $81 if it can get $82 back.” He also points out that most of the cheap oil has already been extracted. It’s actually quite simple to understand. Producers in aggregate will start by extracting the cheapest oil until there is no more and then move up the cost curve to maximize the profit. The cost curve looks like this.

$15-$25: Onshore oil. We don’t have much of this type of oil left. Clearly this type of oil is somewhat cheaper as it’s not as costly to install and fix an oil rig when it’s on land. Onshore oil peaked and declined in 2005 globally. $50: Offshore oil. This is a more expensive type of extracting as you would now need helicopters and ships to fix many of the same things as you could do on land before. Off shore oil could be the North Sea or the US Gulf coast. However, in recent years there was not enough long term supply of this type and fracking became popular.

$70-$90: Fracking – This is a natural gas technology that is actually quite old and has gained popularity in the US. It started to take off in 2009 when the oil price had reached a level where it would be profitable, but the problem lies in the fact that the supply could be limited by 2020 and no other country with available resources has found it economically sound to extract oil anywhere near the same magnitude.

$125-$150: Artic oil – It becomes much more expensive as you would need to transport your equipment a long way in an unfriendly environment, not to mention the climate conditions that make the whole process much more complicated and therefore more expensive.

$200+: Ultra deep off shore oil – This is a source of oil that can found off the shore of Brazil. While the supply is vast, it’s an extremely costly process to extract the oil miles deep and some of the technology required is not even properly developed.

In the short term, the price can clearly dive to a very low level. There’re several reasons for this. One reason is the difference in variable and fixed cost. All oil investments require vast capital expenditures that have to be paid up front. When these costs are paid they are basically “sunk”. That means you base your decision of whether or not to continue the production due to the short term variable/marginal cost and not the total cost. In the short run, it can lead to an oversupply that will drive down the price of oil.

Ask The Investors: Should I invest in an inverse S&P500 in an overheated market?

When deciding to take a short position an inverse index, it is likely going to be a better choice than a single security. The risk of shorting a single stock, bad as it might be, is that it can be bought out by a bigger company and as a result the stock price will move against you. Another risk is that you would have to worry about a call on your short position, which is a very stressful situation to be in. As a concept, Preston and Stig can see why it might be a good investment for some types of investors. However, Stig says that he has never shorted nor does he intend to do so in the future. As a long term buy and hold investor, his strategy is to rather buy when prices are cheap and simply hold on and avoid the noise and temptation to continuously react in an overvalued market.

Books and resources mentioned in this episode

Morgan’s Twitter: @CommodityMD

Morgan’s book, Oil 101 – Read reviews of this book.

Michael Lewis’s book, Liar’s Poker – Read reviews of this book.

Michael Lewis’s book, Flash Boys – Read reviews of this book.

Hari Ramachandra’s Blog about: The Oil Slump

USA Today’s Article on: Billionaire Saudi Prince Alwaleed Bin Talel

Oil Fundamentals: US Energy Information

Understanding the Demand and Supply of: Oil

Videos that Support this Podcast

Morgan Talking about Oil on Bloomberg


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