The Intrinsic Value of Crude: An Underestimated Commodity


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Abstract

Crude oil prices are ridiculously cheap when compared to the cost of other commodities and equities. For the industry to survive and provide the world with its most important commodity, the price of crude oil must increase dramatically in the near future to break out of the lower tercile historical range it has been caught in since the start of 2020. Another two years of “lower for longer” can only exist if other asset bases devalue themselves to close the gap between crude. A more likely scenario is the positive feedback loop of reduced investment and tightening supply will cause a violent movement upwards for the intrinsic value of oil. 


Key Points

  • Since 1980 the cost of many essential goods, commodities, and indexes have increased while crude spot price has remained relatively flat by comparison.
  • Between 1980 and 2020, average house price has grown by 79.8%, a loaf of bread has risen by 77.2%, the S&P 500 surged 98.6%, and gold has increased 64.6%. Over the same period oil has had a 1.6% upward movement.
  • A higher average 2019 price of $56.99/BBL still only represents a 34.4% escalation since 1980. Prices have undervalued the commodity even before the dual black swan events occurred in 2020.
  • The value of common goods priced in “barrels of oil” instead of USD is currently at or above levels seen in 1999 when crude cost $13/BBL. Oil at $40/BBL today has less intrinsic value when priced against other consumer goods and commodities than it did during the lowest crude price in the last 40 years.
  • If crude price escalation doesn’t outpace the inflation rate, investment will not be spent on developing new reserves which will yield a supply shortage. The result will be a re-valuation of the commodity compared to other essential goods and a violent correction upwards in price.

Introduction

Let’s take it back to 1980. Individuals were rocking big hair and jamming out to punk rock, “Pac-Man” has just been released, Mount St. Helens erupts in Washington, and Ronald Reagan is elected as the President of the United States [1]. During this time one could hop into a brand new car costing $7,200, fill up with gas for $1.19/gal, and run down to the grocery store to purchase a 50¢ loaf of bread with the leftover change [2]. Fast forward 40 years, one would need a bit more cash to hop in a $37,876 car, spend $2.38/gal at the gas pump, and whip out a Visa to spend $2.19 on a loaf of bread [2]. That is because since 1950, prices in the United States have risen roughly tenfold [3]. Why? The rise in prices is partly a reflection of generally positive economic growth, and as demand expands it also creates a moderate amount of inflation. Therefore, as prices rise, the average consumer dollar buys fewer goods as seen in the above example. Now if this is the case, why hasn’t the same phenomenon been experienced by crude oil? In 1980 the average spot price for a barrel of WTI crude oil was $37.36/bbl, and for the first ? of 2020 the average price for a barrel of WTI crude has been $37.97/bbl  [4]. Even though the price of nearly every good or commodity has dramatically increased in the past 40 years, the price of oil has fallen relative to the value of other indexes and remains in a price regime initially experienced by only the oldest members of the current oil industry. Crude oil prices are ridiculously cheap when compared to the cost of other commodities and equities. Unless the overall market falters, the downward pressure on oil prices created by COVID are creating a scenario where prices in 2021 must correct upward due to the growing price spreads that have become disproportionate over the last 40 years. 


Everyday Goods

In order to understand how cheap crude oil truly is, an investigation into the price spreads between the cost of a barrel of oil and everyday goods creates a common benchmark that can be explored. The two candidates chosen for comparison will be median home price in the United States and the price of a loaf of bread since two of the three basic needs of life are food and shelter. As stated before, the cost of a loaf of bread in 1980 was 50¢ and after forty years of inflation, that price rose to $2.19 in January of 2020 [2]. Therefore in 1980, one could buy nearly 75 loaves of bread for the cost of one barrel of WTI crude oil but in 2020, that number has shrunk to a mere 17 loaves of bread as seen in Figure 1 below. In more conventional terms, the price of crude increased 1.61% from 1980-2020 while the price of a loaf of bread increased 77.17%. 

Figure 1: Loaves of Bread Purchased With One Barrel of WTI Crude Oil (1980-2019) [15]

Similar to the dramatic increase in food prices since 1980, the median home price has also dramatically increased since Ronald Regan was in office. Back in 1980 the median sales price for houses sold in the United States averaged $64,750 [4]. By 2020 that average has increased to $321,100 [4]. Yet another dramatic increase in price for a basic necessity of life. The 79.83% increase in median sale price for a home in the United States dwarfs the 1.61% rise in crude forming the backbone of the argument that the price of crude oil is far too low. Individuals have a continued need for food and shelter. As the population grows, it ensures demand for these basic necessities is constantly being driven up. The same remains true for energy consumption, yet crude oil price has not shown an equivalent trend. 

Another way of looking at how low crude is truly valued is by considering oil barrels as a “currency” instead of dollars. For example, the above scenarios ask “how many barrels of oil are needed to purchase a loaf of bread or a house?” By using this method of valuing the commodity, the intrinsic value of oil can be seen to cycle as its price has fluctuated over time. Figure 2 shows the cost of a house and a loaf of bread in “oil barrels” between 1980 and 2020.

Figure 2: Cost per Barrel of Oil for Average House Price and Loaf of Bread 1980-2020 [16]

The blue curve on the left y-axis shows how many barrels of oil it has historically taken to purchase an average house in the United States while the red curve on the right y-axis represents the number of barrels of oil needed to buy a loaf of bread. A green line has been drawn when the highest number of barrels were needed for a home purchase during Q1 1999. This means that oil was highly undervalued compared to other essential items, which also corresponds to the low price environment during that period of about $13 per barrel. Even though oil is now hovering around $40 per barrel, the graph is showing that oil is once again nearing an equivalent low value compared to other necessities seen in 1999. 


Stock Market 

Now that it has become clear there is a large disconnect with the growing prices of everyday goods necessary for survival, how does the price of crude oil compare to the level and health of the economy? Since in many ways the stock market is a leading indicator of the economy and a predictor of where the economy may go, comparing the performance of the stock market to performance of crude oil should be an excellent barometer for whether or not a disconnect exists. To compare the two, WTI spot prices will be compared to the Wilshire 5000 Total Market Index and the S&P 500. 

Figure 3: Price Spread Between The Wilshire 5000 and WTI Spot Price [8]

The Wilshire 5000 is a market-capitalization-weighted index showing the market value of all U.S. stocks actively traded in the United States, while the S&P 500 is a stock market index measuring stock performance for 500 of the largest companies listed on stock exchanges in the United States [5,6]. Both indices are intended to measure the performance of publicly traded companies headquartered in the United States, one much larger than the other. Basically, the Wilshire 5000 is meant to track the progress of the overall stock market while the S&P 500 indicates the performance of the largest, and typically top performing, market participants. Back in 1980 the value of the S&P 500 index averaged 119.57 over the course of the year while the Wilshire 5000 averaged 2.16 [7,8]. Fast forward forty years, and the index value for the S&P 500 rose to an average of 27,955.79 so far in 2020 and the Wilshire index has averaged 147.67 [7,8]. That is a 98.54% increase for the largest and highest performers in the stock market and a 99.57% increase for all market participants. If the economy grew by close to one hundred percent during this time, why would crude oil prices rise less than two percent? The disconnect between the overall economy as evidenced by the performance of the stock market and crude oil prices is yet another argument that the price of crude oil is disproportionately low. 


Commodities 

Clearly there is a disconnect between the price of crude oil, essential goods for survival, and the performance of equities in the stock market. But what about other commodities? Economic principles state that as the demand for goods and services increases, the price of goods and services rises. Since commodities are used in the production of goods, the price of commodities is expected to change over time in relation to the goods. That does not appear to be the case for crude oil, but it might just be the case for gold and another common commodity in the energy industry, coal. 

Figure 4: Price Spread Between Gold Price and WTI Spot Price [11]

Taking a journey back to the year of the “Miracle on Ice”, coal was selling for an annual average of $51.58/ton and gold was bringing in $614.75/troy ounce that year [9,11]. Jump forward to the year of the coronavirus, coal is currently averaging $61.27/ton on the year and gold is fetching a premium of $1,736.68/troy ounce [10,11]. Even with coal being phased out of the global energy mix, and an expectation for price to follow the decrease in demand, the price of coal has still increased nearly 16% in the past forty years. Gold is very similar to the price increases seen for everyday goods, experiencing a 64.6% increase in price since 1980. The disconnect between commodity prices, even when price schemes are based on the same principles, finishes forming the entire body of the argument that the price of crude oil is historically low. 

By once again comparing the price of these monetary instruments in “oil barrels,” a value disparagement can be seen relative to the purchasing power of crude. Figure 5 shows a historical representation of the number of barrels required to buy an ounce of gold on the left in blue and a share of companies in the Wilshire 5000 index in red on the right. 

Figure 5: Cost per Barrel of Oil for Gold and the Wilshire 5000 Index 1980-2020

The green line is the previous peak representing low oil value in Q1 1999 for the Wilshire 5000 and in Q1 2016 for gold. Through Q2 2020, nearly double the number of barrels are needed to purchase an equivalent amount of both gold and the Wilshire index compared to the previous historical peak. Although an argument can be made that oil does not currently hold much value, it is important to remember that commodity values will cycle between high and low, so the greatest opportunity for undervalued assets exist during the trough of a low cycle.


Inflation Rates 

Positive economic growth and inflation make everything more expensive, but the latter has a greater influence on purchasing power. Inflation by its very definition is an economic phenomenon that has an increasing change in the price of goods and services [12]. Taking it a step further, price inflation decreases people’s purchasing power to pay for goods. Figure 6 shows the annual U.S. inflation rate from 1980 to present.

Figure 6: Historical Annual U.S. Inflation Rate [13]

With the exception of 2009 when the annual inflation rate average was -0.34%, inflation rates have been above zero for every year since 1980. Naturally, the price of goods, services, and commodities have also increased over time. This is evident by the price of everyday goods like bread increasing nearly 80% and certain commodities like gold increasing over 60%. But if inflation and economic growth are responsible for higher prices, why is crude still so cheap? 


Moore’s Law 

A possible answer to this question might lie in the technological advancements made in the oil and gas industry over the past forty years. This concept relates to Moore’s law which refers to the perception that the number of transistors on a microchip doubles every two years while the cost to produce the chip is halved [14]. Essentially, Moore’s Law states that we can expect the speed and capability of our computers to increase every couple of years, and we will pay less for them [14]. While technology is certainly accelerating the capabilities of the oil and gas industry, these concepts eventually reach a point of diminishing returns. There becomes a threshold where the bottom line cannot be driven any lower and a barrel of oil cannot possibly be produced any cheaper without new innovation. The industry is reaching that level now. So if technological advancements in the oil industry have kept the price low, why haven’t technological improvements for automobiles or mining kept the costs of cars and gold depressed? It is because technology can only improve the efficiency of a process so much, and once a certain point is reached, the price of the good becomes determined by supply and demand within the global economy. 


Conclusion

The start of the decade has been wild with 2020 seeing historically low prices due to the dual black swan events of the coronavirus pandemic and Saudi/Russia price war. The problem is, oil prices undervalued the commodity even before the market tanked and crude commodity prices were sent into a tailspin. Compared to the change in price of other global products over the last 40 years, crude is currently extremely cheap. Throughout 2019, the average price per barrel of WTI crude was $56.99, up significantly from current 2020 prices [3]. With demand increasing year over year, the price should have followed the increased demand of other global products like gold, houses, and bread; yet the price only increased 34.44% from 1980 to 2019. Utilizing gold as a baseline for percentage growth, one would expect the price of oil to be closer to the $105 range. Even though WTI lived in that range for nearly five years before crashing in 2014, those highs will not be seen again unless a dramatic amount of supply is permanently brought off the market or the value of the commodity has a correction. The last time oil appeared to be on the higher side of the commodity value cycle was in 2014. Since then the intrinsic value for the commodity has continued to slide compared to other valued assets. If oil does not outpace dollar inflation, new reserves will not be created and the world will not escape the current supply crunch. The continual de-valuation of this essential commodity while others continue to rise will result in individuals and institutions investing capital in other places leading to an even larger supply shortage. As a result, prices will still eventually be forced to correct in order for crude to re-value itself towards other global commodities. 

Figure 7: Inflation Adjusted Crude Oil Prices Since 1950 [18] 

The above figure illustrates crude oil prices adjusted for inflation since 1950 [18]. Although real crude oil prices were below $10/bbl until 1974, adjusted for inflation those values are closer to the $25/bbl range before spiking to over $100/bbl in the early 1980’s. Oil prices exploded from 1973 until 1980 when the bubble burst and prices returned to normal – however they were much more volatile from then on. With oil hovering below the $40/bbl range for the past month, this price region puts current oil prices in the bottom tercile historically. Supply and demand principles aside, a more reasonable price region that oil will soon need to return to is the $55/bbl range in order to keep up with the ever increasing price of global goods and services taking into account the surge of technological improvement in the industry. Therefore, for the industry to survive and provide the world with its most important commodity, the price of crude oil must increase dramatically in the near future. Another two years of “lower for longer” can only exist if other asset bases devalue themselves to close the gap between crude. A more likely scenario is the positive feedback loop of reduced investment and tightening supply will cause a violent movement upwards for the intrinsic value of oil.


References 

[1] http://www.thepeoplehistory.com/1980s.html 

[2] http://www.thepeoplehistory.com/70yearsofpricechange.html 

[3] https://fred.stlouisfed.org/series/WTISPLC 

[4] https://fred.stlouisfed.org/series/MSPUS

[5] https://www.marketwatch.com/investing/index/w5000?countrycode=xx 

[6] https://www.marketwatch.com/investing/index/spx 

[7] https://finance.yahoo.com/quote/%5EGSPC/history/?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAJaI-tXpi32qTeAZexagu10-wen7TO4gYydWdGdIKbSyGupGuvTihGghQPGFta8JtLTP_W9VSSjfdrBMtw20x3AC56E71LObGjvRwu1EtIPC4-z20ycOAqyuFhT59fzmJXaBr4AVL87qKWNmdDgl5VYtbNPaDHmWhyYOIcriUuj- 

[8] https://fred.stlouisfed.org/series/WILL5000INDFC 

[9] https://www.eia.gov/totalenergy/data/annual/showtext.php?t=ptb0709

[10] https://fred.stlouisfed.org/series/PCOALAUUSDM 

[11] https://fred.stlouisfed.org/series/GOLDAMGBD228NLBM 

[12] https://smallbusiness.chron.com/inflation-effect-purchasing-power-money-696.html 

[13] https://inflationdata.com/Inflation/Inflation_Rate/Long_Term_Inflation.asp

[14] https://www.investopedia.com/terms/m/mooreslaw.asp# 

[15] https://fred.stlouisfed.org/series/APU0000702111#0 

[16] https://fred.stlouisfed.org/graph/fredgraph.png?g=wnaZ

[17] https://fred.stlouisfed.org/graph/fredgraph.png?g=wnb1

[18] https://inflationdata.com/articles/inflation-adjusted-prices/historical-oil-prices-chart/

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