Investing in Oil & Gas: Why a Supply Crunch Looms: Demand Boom, Discovery Drought Signals Oil Profits Windfall

• Oil and gas demand remains high globally, with increasing demand from India and Africa offsetting economic weakness in China.
• Lack of new discoveries and rapid depletion of US shale reserves could lead to supply shortfalls in the medium term.
• Potential for oil price spikes due to geopolitical risks around key chokepoints like the Gulf and Red Sea.
• US oil and gas industry very dynamic and entrepreneurial but facing some personnel issues due to perception of the industry.
• Natural gas oversupply in the US has led to very low prices, stimulating LNG export projects in Mexico.

Oil Executive Bullish on Prices Despite Challenges

With oil prices steadily above $70 per barrel, the oil and gas sector may offer attractive investment opportunities. However, perceptions of the industry’s future prospects remain mixed among investors. This article will analyze current supply and demand dynamics, geopolitical factors, personnel issues, and pricing trends to assess the investment case.

Strong and Growing Demand

Interviewee Neil Young, Managing Director of Elixir Energy, notes that while economic growth in China has slowed, oil demand globally remains robust. In particular, India’s economy continues its rapid 7% annual expansion on the back of its massive population base. Africa too is experiencing solid population and economic growth that will necessitate increased oil consumption. Together, emerging demand from India and Africa seems poised to offset any weakness from China.

In developed economies like the United States, economic and oil demand growth are both extremely strong at present. With the global economy’s continued reliance on oil and natural gas, Young believes overall demand seems likely to keep rising for years to come. He states: “These are energy-dense useful products...there’s a massive multi-trillion dollar of sunken capital involved in producing and moving them.”

Risk of Supply Shortfalls

On the supply side, the picture appears more uncertain. Young highlights that oil discoveries have lagged rising demand significantly in recent years. Rapid 8-10% annual depletion rates seen in some US shale plays also necessitate substantial capital investment just to offset decline rates. With the lack of new conventional discoveries and shale drilling heavily dependent on sustained high prices, the current supply balance could be precarious.

Young warns: “Unless EV take up is much higher and replacements for oil are signed more quickly than they have been then the pressures would suggest...that oil prices could well rise.” The potential for supply shortfalls and price spikes may offer upside for investor returns.

Geopolitical Risks

Heightened geopolitical tensions represent further supply risk factors. Recent incidents around the Red Sea and Strait of Hormuz demonstrate the ability of regional conflicts to threaten chokepoints critical for oil transport. Young assesses that a serious escalation of Middle East conflicts could conceivably send prices skyrocketing: “Oil prices could double or treble easily.”

While these severe spikes tend to self-correct through economic recessions, big upward moves would likely prevail for a period of time. Investors should monitor flashpoint regions closely, as an outbreak of conflict could generate windfall profits.

US Industry Innovation but Facing Personnel Issues

America’s oil and gas sector stands out for its dynamism and innovation. Improved techniques have driven US hydrocarbon output to unprecedented highs, despite pessimistic predictions of peaked production in decades past. However, Young notes that continual industry staff layoffs have winnowed personnel, leaving an experience gap: “Although US oil and gas production's never been higher, the industry feels a bit old in terms of its personnel.”

Paradoxically, Veteran staff dominate boardrooms, while bright young talent often seek alternative careers due to environmental perceptions of oil and gas. Overcoming this emerging demographic wall will be key to sustaining sector vitality.

Natural Gas Dynamics

For natural gas, massive increases in US shale production have created serious oversupply conditions domestically. Prices around $1.50 per MMBtu are unlikely to be sustainable long term. However, liquified natural gas (LNG) exports are beginning to ease the glut.

Young highlights that with the Biden Administration blocking new Gulf of Mexico terminals, projects are progressing rapidly on Mexico’s West Coast instead. Accessing stranded West Texas gas for export to higher-priced Asian buyers should begin clearing the oversupplied market. Young projects that “taking that away liquefied and shipped to Asia then that should be a significant foot off the pedal” in terms of depressed US gas prices.

Current indications suggest a favorable risk-reward balance exists for oil and gas investors. Strong oil demand growth globally appears likely to tighten markets, while geopolitical flare-ups could drive intermittent price spikes. Key questions remain around sustaining production growth to meet demand. Innovative application of new techniques has provided resilience so far, but demographics may pose a looming unforeseen threat. For nimble investors, oil and gas offers appealing value with structural supply-demand deficits over the medium and long term.

The Investment Thesis for Oil & Gas

• Robust oil demand growth projected from India, Africa and other developing markets
• Supply struggling to keep pace with demand growth due to a lack of new discoveries
• Persistently high prices needed to support expensive shale drilling operations
• Geopolitical flashpoints like the Middle East could send prices spiking higher
• Innovations have boosted US output but demographic issues emerging
• Target oil and gas industry funds with exposure to prolific shale basins
• Monitor geopolitical developments closely for potential price upside triggers
• Maintain medium to long-term investment horizon as fundamentals strengthen

The overarching macro theme permeating the oil and gas sector is the growing global supply-demand imbalance. Over the last decade, rampant US shale output increases managed to keep pace with rising world consumption. However, with shale drilling heavily dependent on sustained high prices, the limits of exponential production growth are approaching. Neil Young summarizes the emerging quandary:

“There have been some great discoveries...but they don’t replace the 100 million barrels a day that are consumed just now and so the market does feel balanced...The discoveries haven't matched demand for many many years now.”

This widening wedge between global consumption and new discoveries/resources creates a structural deficit. Economic theory suggests that such conditions tend to result in higher prices over time as buyers compete for scarce supplies. With economies of scale also favoring larger incumbent producers, the emerging supply shortfall points to a period of exceptional profits across the oil industry.