What will happen to energy prices?
That question is on the mind of nearly every investor these days.
So I turned to one of the most brilliant commodity experts I know to discuss the situation.
As Chairman of Sprott U.S. Holdings, Rick Rule is influenced by years of experience and success.
I recently interviewed him to get his take on the current energy and commodities environment – and to discern his No. 1 principle for investing.
We had quite a lengthy discussion. So today, I’m sharing only the first half of the conversation.
Karim Rahemtulla: First, the easy question. Why are oil prices crashing?
Rick Rule: Markets work; high prices stimulate conservation and production. Conservation reduces demand, and, at the same time, higher prices stimulate supplies. The end result without higher economic growth is higher supply and then lower prices.
Karim: What do you make of the Organization of the Petroleum Exporting Countries (OPEC) conspiracy theories?
Rick: Not much. There is the conspiracy theory that OPEC initially colluded to raise prices by lowering production. Well, that is the job of a cartel! Are the United States and Saudi Arabia now colluding to lower prices? Perhaps, but that conspiracy would not work if demand was stronger.
In my opinion, the cure for high oil prices (and high prices in any commodity) is higher prices. As I mentioned earlier, higher prices lead to greater consumption efficiency or conservation, which leads, in turn, to lower prices in the absence of increasing demand. On the flip side, the cure for lower prices is lower prices, as lower prices stimulate demand.
Karim: How long will the junior oil companies stick around?
Rick: Oil and gas companies are better capitalized. They have better access to bank credit than juniors in the mining sector do. That’s a negative as it allows them to stick around longer in an irrational pricing environment. Those juniors that feasted on bank credit will be in trouble, however, as new access to credit is drying up.
Karim: You’ve got a lot of potential positives for oil: low interest rates, emerging markets recovery, a European recovery. But the dollar is also getting stronger. How will this play out?
Rick: When it turns? Major U.S. producers that say they are profitable at sub-$50 oil are delusional. But they can produce below the total cost for extended periods of time. Natural gas took six years to work out post-1981.
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Oil’s lower price environment will not last that long, because much of the growth has come from unconventional supplies. [These supplies are] short lived by nature and easier to shut down, thereby reducing supply or the growth of supply. The number to look for is not only the slowdown of drilling, but also the decline in well completions. Decline rates will take supply off the market. Demand recovery is the key, and that is unpredictable. People forget that we are still net oil importers. The decline in prices is a major benefit for the economy and should lead to more economic growth, ultimately bridging the gap that exists between supply and demand.
Karim: What are your thoughts on natural gas and liquid natural gas (LNG)? Are we seeing higher lows?
Rick: The next 18 months are going to be fairly trying. You’re seeing increased supplies, like the free natural gas that comes from the oil wells in places like the Bakken. In the short term, the shortage in oil and gas storage is also problematic. That is pressuring prices. But gas is also crowding out coal because gas generates less carbon. And now the lower prices are also competitive with coal on a pure-price basis.
The critical mass in the consuming market is also a positive factor that should allow for better prices. Seaborne LNG prices surged as Japan replaced nuclear electric generation with LNG in the wake of the Fukushima disaster. As the markets adjusted over the next four years, a supply response has restored seaborne gas prices to previous levels. LNG pro-forma was based on post-Fukushima pricing, which doubled the price of seaborne natural gas to $18. Now prices are closer to half that.
Karim: So why are LNG companies trading at such elevated levels?
Rick: I have no polite answer to that!
Karim: What do we need to see for prices to rebound in the energy sector?
Rick: We need a sustained recovery that features wage growth. Without a sustained recovery with better fundamentals, it’s hard to see higher commodity prices in the near term. In the absence of a sustained recovery, we will see supply destruction, which, in the end, will lead back to higher prices as fewer new supplies and new suppliers are in the market.
In Monday’s issue, I’ll share our discussion on the metals sector.
And the chase continues,