March 29, 2022

3 Fund Chieftains Explain Why Oil Prices Will Keep Rising

To Britt Harris, Marcus Frampton, and Sean Bill, big forces are aligned to buoy energy costs for a while.

Reported by Larry Light

Oil has topped $100 per barrel. The war in Ukraine has something to do with that, as the West shuns Russian crude. Pandemic-induced economic disarray is another factor. Regardless of what happens on the geopolitical or economic scenes, the world likely is in for a prolonged spell of high, even triple-digit, petroleum prices.

That’s the word from three asset allocators we contacted, two from heavy oil-producing states (Alaska and Texas), one from a less carbon-intensive one (California). Oil probably is going nowhere other than up, in the eyes of Britt Harris, Marcus Frampton and Sean Bill. A number of asset managers we talked with echoed that sentiment.

This isn’t good news for consumers, who are struggling with elevating inflation, the most prominent element being spiraling gasoline prices. It is good news for energy investors, though—and our trio of asset owners all have energy investments, although not in overwhelming amounts, in the interest of diversification.

A typical example of energy producers’ stock market good fortune: Exxon Mobil, the largest American oil company by revenue, has enjoyed a 150% stock price increase since its 2020 low point. Earnings and revenue have burgeoned. Nonetheless, its price/earnings ratio is at a relatively thrifty 15, a lot lower than the S&P 500’s average of 20. “From a value standpoint,” says Sean Bill, CIO of the Santa Clara Valley Transportation Authority, or VTA, reflecting on energy stocks in general, “this is cheap.” He adds that energy stocks tend to do well when interest rates are increasing, as they are now.

Spurting Oil

Undergirding these happy Wall Street tidings is that oil prices are on a relentless upward march. West Texas Intermediate (WTI) crude, the U.S. benchmark, now changes hands for $103. Brent crude, the international standard, is just below $110. The top Brent price this century was $146, reached in 2008. The financial crisis and Great Recession sent that skidding.

The stage for the current situation was set in the early part of the last decade, as a drill-baby-drill attitude swept the oil industry. That post-crisis exuberance, where independent frackers helped stoke the mania, lasted until around 2016. An over-abundance of oil led to another price dive—and the pandemic only made things worse.

Oil giants such as Exxon pulled back on their capital spending, and even gung-ho frackers suddenly grew restrained. Lowered capex remains the rule nowadays. In addition, climate activism seized many investors and pressure grew to limit carbon-based fuel output.

At the pandemic’s March 2020 onset, oil plunged to $18, and briefly was negative. With economic recovery, WTI surged anew. A depleted inventory of oil greeted rocketing demand, fed by government stimulus and lowered interest rates. Even before the Russian invasion, “we were sitting on a powder keg,” says Rodney Clayton, a portfolio manager at Duff & Phelps Investment Management. “Production didn’t recover, as demand did.”

Russia’s invasion of Ukraine propelled the price ever higher, amid import sanctions and war-related shipping interruptions. The price this year could reach $150, Clayton ventured.

Then there’s the matter of long-term commodity trends, which are on the upswing. The latest growth follows a recent period of several years when commodities, oil included, were seeing prices dip. “These cycles are long-lasting,” notes Ed Egilinsky, Direxion’s head of alternatives. “We’re in the opening innings.”

At some juncture, however, oil will reach a level that consumers can’t abide. “It will be above $150,” predicts Scott Colyer, CEO of Advisors Asset Management. “That will destroy demand,” he says, with people driving less or taking mass transit.

What the Allocators See

Our three investment chieftains, interviewed due to their expertise in the energy field, have different vantage points about oil’s price ascent and the reasons behind it. But all recognize that lofty oil is in our future for some time. Taken in alphabetical order:

Sean Bill, who leaves his post next month to join private credit fund Prime Meridian Capital Management, foresees oil possibly climbing to $160 this year and perhaps $200 next year.

Bill argues that “regardless of Ukraine, there is an upward bias” to oil prices. The only thing that could reverse that climb, he adds, is an economic slump. After all, that’s what happened to end the 2008 oil surge.

Right now, the oil futures market is in backwardation, meaning near-term contracts are more expensive than later-dated ones, according to CME Group: The difference between the near-month contract (May) of $106 and the one 12 months later, at $85, is historically very steep. Instead of the current $21, the spread is usually around $2 or $3.

The present slope shows, among other things, that traders are scrambling for supply now and are paying top dollar for the oil. It also implies that traders think crude prices will come down in coming months. To Bill, the unusual shape of the curve indicates that prices will end up swinging higher—“analysts’ estimates are too low,” he says—or even if the prices don’t go up, energy stocks will do well. That $85 oil price in a year still is pretty good.

The VTA has no direct investments in energy, other than the sector’s 2.5% portion of the agency’s investment in a Russell 3000 fund.

Marcus Frampton, CIO of the Alaska Permanent Fund Corporation, the state’s sovereign wealth fund, is bullish on energy stocks. Frampton sees the supply constraints sticking around. “Fossil fuel demand has come roaring back from COVID, and the supply side is an absolute mess,” he says. “Sadly for American consumers at the pump, I think the outlook for oil and gasoline prices is upwards from here.” To him, that means well into the triple digits “for the foreseeable future.”

Part of the blame, he contends, is “the vilification of American oil producers in Washington D.C., while geopolitical risks around international supply” expanded. Unless the Federal Reserve makes a mistake and tightens too much, he goes on, the economy should be OK, despite a few bumps from high-priced oil.

His fund has around 4% of its assets in fossil fuel stocks: oil and gas, and also coal. “Our exposure isn’t enormous, slightly more than the benchmark weight,” he says. “But in a world where so many folks are divesting from fossil fuels, even that positioning seems extreme at times.”

Britt Harris, president and CEO of the University of Texas/Texas A&M Investment Management Company (UTIMCO), hails from an historic oil-centric state, which also happens to be the No. 1 producer of renewable energy. He last year relinquished the system’s CIO job to his deputy, Rich Hall. Harris believes that replacing fossil fuels with renewable energy sources is a worthy goal, but argues that implementing that transition has been bungled.

As a result, we are mired in the mess we’re in today. “The reason energy prices have risen is simple common sense. Hydrocarbon supplies have been reduced without a commensurate ability to fund that reduction with other, cleaner fuels,” he finds.

In Harris’ view, “inexperienced and naive planners have taken the wheel of global energy supply. Their devotion to increasing renewable sources of energy is laudable. Their implementation, however, is naive and fanciful.”

Although Harris didn’t sketch out what he perceives as their failings, many others have maintained that a shift to renewables won’t be quick and easy. It will entail using “transition” fuels such as natural gas, whose carbon output is one-third less than petroleum. Trouble is, environmentally minded policymakers tend to tar all fossil fuels with the same brush.

While Harris doesn’t put a number on it, he makes clear that higher oil prices are likely. Thus, “either prices must go up so that additional energy supply will be produced to fill the gap,” he says, or demand must flag, which typically leads to an economic slump.

Of the three fund heads we spoke to, Harris’ energy exposure is the biggest. UTIMCO owns 2 million acres of oil-rich land in western Texas, which has generated around $1 billion in oil and gas royalties over the past eight years. The land also has solar fields, wind turbines, and farming. The endowments’ portfolios have about 5% in energy, down from 17%, when Harris came to UTIMCO in 2017.

A carbon-free future may await the world. In the meantime, the tab for running that world, with its most widely used fuel, will escalate.