The Red & Blue Pills in Energy.

(Throw that Supply & Demand model out)

The Gist: (1) Development costs drive long-term trends in oil prices more so than supply & demand balances. (2) Development costs are driven by productivity gains.

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Neo is the main character and hero in the Matrix trilogy (p.s. The first one was the best and the rest were weird).

Morpheus is the guide and mentor to Neo.

There is a pivotal moment where Morpheus asks Neo if he would rather consume a red or blue pill.

The red pill represents the willingness to learn a potentially unsettling truth that could change Neo’s entire belief system.

The blue pill would have Neo simply accept his present reality and be comfortable with things the way they are.

I find this same choice is given to us energy analysts long before we begin our careers in energy.

We are brought up in the world of econ101 which makes us rely heavily on supply and demand curves and “balances”.

The blue pill is what we have been taught in the past. It tells us that to understand where prices are headed, we must forecast demand and supply.

How do you get the demand forecast? Simply regress it vs. GDP, population growth, and income growth. Right?!

How do you get the supply forecast? Take a look at spending patterns and projects that are set to come online. Spice it up with some analysis of OPEC production forecasts because you have a buddy who has a third cousin who heard from a relative with a brother who works at ARAMCO.

Voila! you have an idea of where the balances are headed.

In the blue pill world, if demand is greater than supply Neo is bullish.

If supply is set to rise faster than demand, Neo is bearish.

But what if I told you, that history does not agree with this version of reality?

In fact, what if I then told you that it is not demand and supply that drive price but rather quite the opposite?!

This is the world of the red pill in energy.

Ingest it and go down the rabbit hole with me.

What if I were to describe it differently as a feedback loop where rising prices generate forecasts of future deficits, whereas declining prices result in anticipations of forthcoming surpluses?

If you were an energy analyst in the 1970s you may have noticed that along with the supply shocks, demand also decelerated.

The two rose and fell together so that by the end of the decade they both exited the period at lower rates of growth than when the period began as shown on the left below.

But the 1970s is a distant memory where most of us had to read about it in books/podcasts including this energy analyst.

Most of us remember and lived through the 2000s cycle.

Yet the same thing occurred, the demand and supply balances moved together as shown on the right!

We weren’t alone, every Neo who came before has lived with this phenomenon where demand and supply have always moved together during all prior bull markets in oil as evidenced below.