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The article below is an excerpt from our Q1 2024 commentary.
WTI Crude Oil
1/1/1970: $3.18
2/15/1981: $34.30
1/1/2000: $25.55
7/14/2008: $145.18
The theories of King Hubbert are about to become once again highly relevant. What follows is the first in a series of essays in which we will cover many of his most important views. Hubbert is best known for “peak oil,” his framework for predicting when global oil production will peak, plateau, and rollover. We have written about peak oil in the past and will revisit it in an upcoming letter. For those interested in the interim, we recommend listening to our debate with Doomberg on Adam Taggart’s podcast from January 25, 2024 (click below to watch the interview).
Today’s essay focuses on how Hubbert’s theories could have been used to predict the massive crude bull markets of the 1970s and 2000s. Using them as a guide, we will explain why we believe we are on the verge of a bull market of similar magnitude today.
In the 1970s, oil advanced tenfold as the world experienced two distinct oil crises: the Arab embargo of 1973 and the Iranian revolution in 1979. In the 2000s, oil advanced thirteenfold, stopped only by the onset of the global financial crisis in 2008, the most severe economic dislocation since the Great Depression.
During both periods, “Hubbert’s Peak” captivated the investor zeitgeist and dominated discussions of why oil prices were so high. However, in retrospect, we know these fears about hitting “Hubbert’s Peak” were wrong. Oil production grew sharply in the twenty years following the 1970s and the decade following 2008. Following each spike, oil entered long, grueling bear markets, and Hubbert’s theories became widely discredited and almost entirely forgotten. Nevertheless, Hubbert’s teaching provided lessons that predicted both bull markets. To reject his theories out of hand would be ignoring their essential principles. Armed with Hubbert’s theories, an analyst in either 1970 or 2000 could have confidently predicted the huge bull markets that were to come. A similar situation is unfolding today.
Both bull markets were driven by predictable, albeit under-appreciated, changes in non-OPEC oil supply. In the 1970s, those changes took place in the United States. By 1970, the US was by far the world’s largest oil producer. Production peaked in 1970 at 11.3 mm b/d – significantly greater than the combined production of Saudi Arabia and Russia, the world’s second and third-largest oil producers. Between 1965 and 1970, US production growth represented 30% of total non-OPEC growth. Although US production had spent the preceding sixty years growing steadily, it was about to roll over and spend the next forty years declining. Hubbert predicted that peak fourteen years earlier in his dinner speech at the American Petroleum Institute in 1956. In that presentation, Hubbert presented two possible scenarios. In the second scenario, which he confirmed in 1962, he predicted US production would peak in 1970 at 10 mm b/d.
Production peaked in 1970 exactly as Hubbert predicted, and by 1976 production had already fallen 15% or by 1.6 mm b/d. Lost supply and surging demand meant the US’s need for imported oil surged. Between 1970 and 1976, US net imports more than doubled, rising from 3.4 m b/d to nearly 8 m b/d by 1976. The dramatic increase in US net imports gave OPEC and Saudi Arabia a significant advantage in market share and pricing power. Between 1970 and 1974, OPEC went from representing 46% of global crude production to 52%. OPEC first leveraged its improved market share in 1973, when the Arab oil producers engineered a tripling of oil prices in only six months in retaliation against the United States’ support of Israel in the Yom Kippur War. After the Iranian revolution in 1979, OPEC again exerted its influence, causing prices to double. Using its new price power related to market share gains, OPEC was able to produce a ten-fold increase in oil prices in ten short years and to change the geopolitical orientation of the world for years to come.
A similar situation developed in the 2000s. Throughout the late 1990s, Saudi Arabia and Venezuela (both OPEC member countries) waged a price war over disagreements around OPEC production quotas. Crude prices collapsed to $11 per barrel in the first quarter of 1999. Demand was then materially impacted following the September 11, 2001 terrorist attacks, putting further downward price pressure on crude. At the same time, non-OPEC oil supply grew sharply in the early part of the 2000s. Russian production rebounded as companies, such as Yukos, began adopting modern Western drilling and oil service techniques. Surging non-OPEC supply and weak demand produced a universally bearish oil market psychology. Although it is hard to believe, most investors in the early 2000s failed to appreciate the coming surge in Chinese oil demand growth.
Despite the bearish outlook, forces were at work in non-OPEC supply that would significantly tighten the market and severely disrupt the bearish narrative, much like what happened back in the early 1970s. Investors and analysts willing to do the original research and apply various geological theories to the modeling of various hydrocarbon basins would recognize what these forces were and how they would impact non-OPEC supply. In its February 9, 2004 edition, Barron’s published an interview with Leigh Goehring (then the Jennison Global Natural Resources Fund manager) titled “Pumped Up: A Natural Resource Maven Sees a Long-Term Bull Market for Oil.”
In that article a crucial point was highlighted: “We are just beginning to see a noticeable slowdown in non-OPEC oil supply, which is bound to pass more power into the hands of the oil cartel. Energy is undergoing a massive underlying change, and people are not yet interested in accepting it. In 2004, the gap between perception and reality will close.”
Over the previous two decades, the two most significant sources of non-OPEC supply growth were the North Sea and Mexico’s Cantarell field. Both fields ramped up in the early 1980s and reached a combined 7 mm b/d by 2004, equivalent to 60% of all non-OPEC growth. By 2004, both fields were on the verge of a significant development that few analysts predicted: they were about to decline. By applying Hubbert’s theories, we were one of the few investors who anticipated the slowdown, and we positioned ourselves accordingly.
Disappointing production in both fields caught nearly everyone by surprise. Based on their first published estimates for each period, the International Energy Agency (IEA) predicted that the non-OPEC oil supply would grow by 6.6 m b/d between 2003 and 2008. Instead, owing to massive disappointments in the North Sea and Mexico, non-OPEC production rose by a mere 2.2 m b/d, 65% below their initial expectations and far less than the 6 mm b/d demand growth over the same period. As a result, OPEC again gained market share and pricing power, forcing crude prices to rise by nearly 350%.
For those who studied Hubbert’s teachings, disappointing supply in the decade of the 2000s was entirely predictable. Our research strongly suggests the oil market is again entering a period similar to 1971 and 2003. For analysts and investors who understand and apply Hubbert’s theories, the investment opportunities are significant.
Over the last thirteen years, the US has provided almost 90% of total non-OPEC supply growth, far more than the US in the period leading up to 1970 or the North Sea and Mexico in the period leading up to 2003. Similar to the US in 1970 and the North Sea and Mexico in 2003, our models suggest the US shale production is about to roll over.
Hubbert believed that production would decline once an oilfield had produced half its ultimate recoverable reserves. This underpinned his prediction that the US would peak in 1970. Similarly, we used our estimates of the North Sea and Cantarell reserves to predict they, too, would roll over in the early 2000s. Combining our proprietary shale neural network with Hubbert’s teachings, we believe the shales have produced over half their recoverable reserves. If our modeling is correct, production disappointments in the shales are rapidly approaching.
Except for King Hubbert in the 1970s and Colin Cambell and Jean Laherrère in the 2000s, no one predicted that the US, North Sea, or Cantarell would roll over. Few analysts today believe the US shales will roll over, but with the help of Hubbert’s theories and our models, we do.
Shale growth has been slowing for several years. The slowdown in non-OPEC supply has already impacted oil markets. The US has been forced to orchestrate a 320 mm barrel release of strategic petroleum reserves and OPEC is flexing its regained market share and pricing power. On April 3, OPEC renewed its production cuts, even though many agencies, including the IEA, anticipate crude deficits later this year.
Crude markets are at an inflection point similar to 1970 and 2003, yet investors remain more complacent than ever. In the early 1970s, the energy weighting in the S&P 500 bottomed at 15% before reaching an all-time high of 35% in 1981. In 1999, energy’s share of the S&P 500 bottomed at 6% before reaching a high of 15% in 2008. As we write, with crude at $78 per barrel – nearly seven times higher than in 1999 – the energy weighting of the S&P 500 cannot break 4%. Investors are convinced energy stocks remain “uninvestable.”
Intrigued? We invite you to download or revisit our entire Q1 2024 research letter, available below.
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