WHEN WILL THE PRICE OF OIL REACH THE BOTTOM? Trader gurus, or “pros” as CNBC calls them, have been calling a bottom in the price of oil and urging investors to buy “cheap” oil company stocks, each step of the way down from over $100/bbl last Summer to $80, $70, $60 and now $56. Last night one of these “pros” produced a chart showing that $56 was the price back in 2007 from which oil broke out and soared to $150. He apparently believes that many traders who missed out on that move 8 years ago had vowed to jump back in and buy oil if it ever got back down to $56 again. Yesterday the price dropped below $58 so we should all get ready to jump in with them, which is of course ridiculous. Talk like this reveals a total lack of understanding about oil and how markets in general behave. If he had looked a little farther back on his charts he would have seen that oil was below $40 until 2004 and at one point in 2002 dropped below $20. In 1999 it was $10 and spent most of the 14 years from 1986 to 2000 between $10 and $20. Oil is notoriously volatile because the market for it is global in scope, and because it is such an important element of cost not only for the driving public, for producing electricity and heating homes, but also for a number of important consuming industries such as plastics, chemicals, trucking and express delivery, airlines, ocean transport, fertilizer and metallurgy. These industries are active in the market trying to anticipate and hedge against future price movements. Furthermore, the volatility attracts speculators including even big banks who in the recent past have purchased mega-tankers loaded with oil to be anchored in storage as a bet on rising oil prices. There are four major elements to the market: 1. Saudi Arabia which is the low cost producer with vast reserves that can be placed into production or withdrawn to influence price. 2. Other higher cost producers who add and subtract from production based on price and available technologies such as undersea exploration and those being used to extract oil from shale and old expired fields. 3. Governments with strategic reserves that can be released or accumulated. 4. The industrial users mentioned above who actively engage in hedging through the futures market. 5. Speculators including giant oil trading specialist firms, banks, hedge funds, other investors and traders. The fundamental forces in the market are those affecting the physical supply and demand of oil. Global demand for oil moves relatively slowly in keeping with economic trends, conservation efforts and alternative energy use, but supply can change somewhat more rapidly. Any one of the first three can move prices by adding or subtracting from supply, sometimes deliberately and sometimes as a result of political unrest and violence. Adding physical supply takes time measured in months or a few quarters, but reduction can come quicky as for example when Libya’s substantial production was cut off by war. Inventories, both private and in the form of government strategic reserves, can buffer changes in the physical supply and demand. While physical supply is far from stable, the great volatility of oil markets is derived primarily from the 5th element, financial speculation which reacts sharply to actual and anticipated movements of supply and demand as well as the psychology of geopolitical disturbances. Moreover, the speculative element has been greatly enlarged in recent years by the extraordinary global increase in financialization, exacerbated by monetary expansion, especially the U.S. programs of quantitative easing. Since oil trade is predominantly denominated in U.S. dollars, recent dollar strength has added a downward impetus to recent price developments. Speculation when there is so much money sloshing around the world can run counter to fundamental physical supply/demand trends for a while, perhaps a few months, but not forever. Speculators can not turn on a dime since there are so many large players involved with large sums at risk, but they must eventually turn and follow the trend of the fundamentals, i.e. physical supply and demand. Once they get on board the trend, however, there is a snowball effect and prices will run ahead of fundamentals until markets overshoot, usually in a final climatic thrust. Market observers at various times in the recent past have estimated that speculation was adding as much as $20 to $30 to the price. Now, of course, that speculative element has to be reversed, which takes time, but after the speculation races ahead of fundamentals for a while it could easily overshoot again by $20 or more to the downside. The bottom could be reached at $40, $20 even $10; there is no downside climax that would surprise me although at the moment would not expect anything below $40 mainly because I think anything below that would bring a Saudi response curtailing supply. Before we set our sights on finding the bottom, we should be looking for the supply response in the form of reduced production, mainly in U.S higher cost shale production, on the order of say 500,000 bpd. The first signs of reduced U.S. output are just now beginning to appear. The faster and farther that the price drops the quicker the supply response will come. I at first thought that a new physical supply/demand equilibrium might come by mid-2015, but the extent and speed of recent declines lead me to believe that it will come much quicker, say by March. The other key factor, Saudi Arabia, I think might hold out for 3 or 4 months of a sub-$60 Brent price (sub-$55 U.S. price) so we have to watch that also. A Saudi response of any kind would probably quickly halt the speculative slide.
Posted on: Sat, 13 Dec 2014 16:43:30 +0000
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