Predictions for the second half

Prediction is very hard, particularly when it’s about the future (Yogi Berra)

My rants about the massive losses some Canadian E&P companies suffered from ill-timed hedges imply that management of those companies is oblivious to the macro-economic picture and incapable of stopping themselves from betting against their own success. It is not a fair criticism unless I am willing to go on record stating the macroeconomic environment for oil & gas prices for the next few quarters.

So here they are:

There is a large and growing global shortage of fossil fuels created by foolish “climate policies” that pretend CO2 causes global warming, policies that have driven capital out of the fossil fuel industry and a resulting decline in the growth of production to a point where demand is outpacing supply. Leaders in Canada and United States are doubling down on this nonsense, and sedimentary basins in North America will see little resurgence of oil & gas supply in a tight market. So I predict prices will remain firm.

How firm?

In the case of oil, I see prices between CAD$80 and $120 a barrel as likely, even with a mild recession worldwide (which I see as inevitable). There is an outside risk of oil falling as low as CAD$50 a barrel and an upside tail of the distribution north of CAD$150 a barrel. Virtually every Canadian oil company that I follow is cash flow positive throughout that range of prices and has no business speculating in the commodity market.

How convinced am I?

There have been several academic studies that demonstrated that oil prices are log-normally distributed. Here is a link to one of them. Prices outside of the CAD$50 to $150 range I have predicted are about three standard deviations from the mean, and have a probability of materializing of less than 5.5% on either end. Hedging for a <5.5% risk should be either avoided entirely or entered carefully to limit the hedging to buying “puts” below the market at the price where the downside damage really hurts. Puts on oil at $60 are inexpensive today.

Writing calls above the market is simply stupid. While the call premiums are useful to help pay for the puts, they cap an upside that in an extreme shortage can be extreme. Several months ago Goldman Sachs recently saw the possibility of oil at US$200 a barrel and currently expects the price to reach US$140 a barrel. So do I if the global energy shortage keeps deepening and we have a cold winter.

Natural gas is another matter. Here the shortage is already so extreme prices in Europe and the United Kingdom have touched levels equivalent (on a BTU basis) to $250 a barrel oil and there is evidence of some substitution of oil for natural gas for power generation in some jurisdictions. No sensible executive should “hedge” against a drop in natural gas prices this winter.

My natural gas price prediction varies by region. In Europe, I see a price of $40 to $50 a gigajoule as likely during the winter, higher than a forecast put out last year that saw $34 a gigajoule as possible and turned out to be low.

The supply-demand situation in Europe has worsened since that time. United States has committed to supply LNG to Europe to help, putting upward pressure on U.S. domestic prices. I see natural gas prices north of CAD$10 a gigajoule during the winter and a likely range (even with a mild recession) of from CAD$5 to CAD$15 a gigajoule. Prices outside of that ranges are four or five standard deviations from the mean and so unlikely as to be unworthy of sensible consideration.

Shit happens. I have been wrong before and I am certain I will be wrong again. But I am holding 80,000 shares of Birchcliff (BIR.TO) and 85,000 shares of Spartan Delta (SDE.TO) as core natural gas holdings together with smaller holdings in key players such as Canadian Natural Resources (CNQ.TO). I hold 5,000 shares of ARC Resources (ARX.TO) but fear management will once again squander opportunity for their version of safety and I can’t stomach holding a larger stake.

Based on my assessment of the probabilities (and with the caution that my assessment is not a certainty and is fraught with risk) I see SDE.TO earning enough to warrant a price in the CAD$30’s and BIR.TO in the CAD$20’s during 2023. My cost on SDE is ~CAD$5.00 a share and on BIR ~CAD$2.00 a share so I am not really hanging out there in terms of my personal risk of calamity.

Since I am posting this on Substack, I can’t escape the reality that my predictions are “out there” and can’t be recanted. Don’t you wish our politicians were held to account for theirs?

The energy trade is not dead and will not end if there is a recession. A recession will see short term declines in commodity prices followed by even higher prices in the subsequent recovery since no supply expansion is likely to take place during a downturn.