"There aren’t really any actual misconceptions, just dumb people versus good, honest people."
-Ted Nugent

Why another paper on energy?

Only a couple of months ago, I wrote an Absolute Return Letter called Addicted to Oil?. The paper attracted lots of comments and questions; hence my decision to re-visit the topic, where I will address most of the issues you raised.

Some of the charts I used in the May letter will be used again this month, but I have deemed that necessary to make my points. Please forgive me for that.

The four misconceptions in brief

The first three misconceptions I discuss below are tactical in nature and will most likely lead to upward pressure on oil prices in the months to come. The fourth and final misconception is structural in nature and could lead to (a lot) more misallocated capital, thus further downward pressure on productivity growth and GDP growth in the years to come.

In no particular order, they are as follows:

1. Oil prices are to a large extent driven by manufacturing activity.

Fact: That is precisely what drove oil prices between 2014 and 2018, but it is no longer the case!

2. With WTI trading at almost $60, most U.S. shale producers are now cash flow positive.

Fact: This simply isn’t true, and the evidence is overwhelming!

3. The US may produce the most oil these days, but Saudi Arabia is still the key swing producer as their reserves are far bigger; hence their production capacity is much bigger.

Fact: The Saudis want everybody to believe that to be the case, but that doesn’t make it any truer!

4. As renewable energy forms gradually replace fossil fuels, many problems will be resolved.

Fact: Whilst it is indeed correct that some of the problems to do with global warming will most likely go away, other problems will only get worse!

Misconception #1 – the key driver of oil prices

I often come across the view that industrial activity is the #1 driver of oil prices and, over time, that has indeed been the case but, these days, the link between industrial activity (as measured by the PMI index) and oil prices is oddly weak (the red square in Exhibit 1).

Exhibit 1: Brent oil price vs. global manufacturing PMI 3-month average, 2014-18
Exhibit 1: Brent oil price vs. global manufacturing PMI3-month average, 2014-18
Source: The Daily Shot (WSJ), FTN Financial