Oil Futures Market: Unwinding the Bubble

Almost every day since July, I have been reading (correction, scrolling through and mostly ignoring) articles declaring an oil price bottom and setting "natural" price targets for oil. In August, those targets were in range between $150 and $200 (last one by Goldman Sachs, I still want to know if their traders listened to their analysts and if so, how much money they lost in result). Currently, the range moved to something like $80 to $100. What a bunch of crap! And I completely refuse to discuss bunk "Peak Oil" theory here.

First of all, I don't know where the oil price is going in the short term. Second, if the price of oil was defined by the supply and demand of the real commodity, the price should stabilize somewhere between $50 and $60, which is the current marginal cost of Canadian oil sands companies and deep water extraction.

I can't seriously accept claims that Middle East costs are reaching $120. Yeah, sure, if you think that Iran's development of nuclear arms, Saudi money going to support the most reactionary, most antisemitic mosques in the world, Venezuela's stupid government spending on arms and "social" projects are parts of cost of oil, I have a dozen bridges in Minnesota for 99 years rent. If you strip all the crap, the cost of Middle East oil still doesn't exceed $25.

The situation in Russia is a little bit worse, but still, the cost of most producers doesn't exceed $40, translated into price of light sweet crude. Deep water oil and oil sands production is the most expensive to extract and thus gives us a good estimate of marginal cost.

So, in the long term oil, should stabilize between $50 and $60. But this is the long term. In the short term, there is a small problem with the oil price. And the problem is, since the beginning of 2007, the price of oil as a commodity was separated from price of futures contracts. Starting in the end of 2006, lots of money went into futures contracts of oil. Hedge funds bought a huge number of oil contracts, creating a bubble which peaked in July. They were helped by sovereign wealth funds, endowment funds and even state pension funds.

In July, the oil bubble popped. I was naive then, and I thought that oil should gradually fall to about $90 by year end and settle to around $50 in couple of years. Boy, was I wrong! I stupidly sold PowerShares DB Crude Oil Double Short ETN (DTO) in August. You know what happened next.

Why does oil keep going down? Surely, at under $40, marginal producers should just stop production and wait until price is good enough for them. That would be true if the oil market was a pure commodity market. But we have a futures market which has been separated from physical market for more than a year. Looks like marginal producers decided to sell future oil production while prices were still high. Can't speak for everyone, but Devon (DVN) did exactly that in August, according to Jim Cramer. Interesting picture: oil already sold for $100+ competes with oil coming to spot and short term future market. Guess where prices should go?

That's why it's impossible to predict short term oil price: margin cost does not define market price. I don't know how long this situation will persist. But in the short term, oil can go up or down. Huge supply of oil in inventories, including floating ones (tankers contracted exclusively to hold oil for several months) creates a ceiling which would be hard to breach short term. Can it go much lower? Sure. I wouldn't bet on $15 oil, but it might happen. Would this price be sustainable? No, hell no. But it can happen. And I probably will be a buyer of U.S. Oil Fund ETF (USO) or something similar then. Can price go higher from here? Sure. But unless we have some big event, like big Middle East war, or war between Venezuela and Colombia, with US participation, I just don't see price above $60 for 2009.

Of course, futures market can still surprise us. But most funds don't have money to create big bubbles now. A lot of hedge funds are under huge redemption obligations. Some of them are gated, i.e. they refuse redemptions, but in any case they are in no position for big speculation. Endowment and pension funds are in worse condition. Most of them probably will replace management for more conservative one (which would be the right move), which will automatically exclude them from any future markets.

Until the oil futures bubble is completely worked out and the price starts reflecting a real supply/demand situation, don't expect expensive oil.

Full disclosure: At the time of publication author did not have any positions in USO or DTO. Positions can change any time.

Comments

[blu:]

Alex,
You are certainly cocky in your assumption that you "know" what the long term price of oil should be.

Supply and demand will determine the price of oil as it always does.
The speculators have been incorporated into the pricing mechanism. Their effect on prices is consequential in the near term but over the long term it is negligible as it will average out with speculated low prices that will be short lived like the extreme highs.

There are many that believe the $147/bbl price is cheap based on available supply for the long term. It seems to me, that if one believes in markets and the law of supply and demand, crude oil is headed north again very soon.

Low prices kill supply development and increase demand. It is a combination punch that will rock most markets.

Yeah I am a believer in peak oil... Better safe than sorry.
I am a small indendent producer in Texas. I have cut my production as a result of the decline in prices. There are thousands of producers like myself who have done the same.

2008 Dec 29 05:38 PM

[jimmy46:]

Why does oil keep going down? Surely, at under $40, marginal producers should just stop production and wait until price is good enough for them.""""""

For some of the recent deep water projects, the TOTAL COST OF PRODUCTION may be $70 or more.

But, most of that cost is upfront drilling for the oil,
once production starts the CASH COST OF PRODUCTION is probably no higher than for shallow water oil.

CASH COST is what drives the extraction industry in the short term,
TOTAL COST is only used for deciding whether to START a new project.

RESULT: NO ONE IS GOING TO HOLD PRODUCTION DOWN TILL PRICES GO HIGHER.

2008 Dec 29 05:39 PM

[Elvsinus:]

Alex your speculative theory is bunk. Your analysis is pure speculation. and Peak Oil is not a myth but reality. You have not factored in the fact that consumption has slowed due to the panic and fear from the financial fiasco. There is no incentive for producers to produce at these prices. It is only a matter of time before the rules of economics reverse the current trend.

2008 Dec 29 06:12 PM

[Commodity B...:]

Nice piece...you should also point out that a large portion of the "run-up" in oil costs was due to the fact that guys like Transocean, Diamond, Schlumberger, etc. were getting ridiculous profit margins on their rigs. Once more of these things get built, the cost of production will naturally go down.

Oil rig builders do not need 50% IRRs to justify the development of new equipment.

2008 Dec 29 06:12 PM

[prudentinve...:]

Oil is a unique commodity in the sense that the marginal cost to produce it, and the marginal value to its consumer are very far apart.

Marginal value to produce it varies by oil source, as discussed in this article, and the consensus seems to be somewhere in the $25-$50 range. Value to the consumer, is probably in the $150-$250 range, and demand begins to drop as this range is approached. as we have seen recently. We don't know how drastic the demand drop would be if oil went beyond $150 as we have not experienced it.

Thus, the price is bound to be unstable within this wide range between cost to produce it and its value to the consumer. So I doubt that its price is predictable.

2008 Dec 29 07:27 PM

[SeekingTruth:]

I believe that oil prices are indeed unpredictable. We never know exactly what the suppliers are going to do. That said, and I am convinced of it, it does NOT mean that there cannot be rays of light on how to bet for the short term in "some" situations.
Parts of 2008, are a case in point, and without writing a treatise on the subject, we had a situation where demand and consumption were FALLING at the same time when speculation/ inflation hedging AND supply were all INCREASING, and a lot of the increasing supply was provided by Saudi Arabia who can tap oil at under $2 per barrel from many of it's largest fields. This is an unsustainable situation and it prevailed long enough to rout the speculators and inflation hedgers and drive prices back DOWN.
Now we are beginning to see the reverse of this situation, and the supply reduction comes first, then we must see if and when the speculation and infation hedging sets in, which is now in the preparatory and uncertainty stage. If these elements remain cowed then the authors predictions are good ones, if they don't remain cowed, it could be back to the races, and therein in lies today's unpredictability.
As I have said many times on these posts, I am not an oil (or energy) expert in the slightest, and l probably never will be, but I do consider myself a keen observer, and many times that will suffice spendidly.

2008 Dec 29 11:10 PM

[Saildog:]

Alex - this article is bunk. The reason for oils price volatility is the almost perfectly inelastic supply and demand curves (even in this very wide price band). Demand has contracted and the price has imploded.

You clearly know nothing about production. Go and read up some stats. Find out what the export land model means. Go and study the mega projects list. Learn what the implications of the IEA's 6.7% decline rates are. Understand the geopolitics of oil.

Wittering on about the price and the various costs of production is meaningless and adds nothing new to the debate.

2008 Dec 30 06:33 AM

[Ferdinand E...:]

Not a believer in peak oil bunk, you say. I tell you how I dealt with this for my students in Bangkok last year, where at least half of them were graduate engineers working for oil companies, and did NOT believe in peak oil. I explained to them as carefully as I could why the oil output peaked in the US - a country with the best technology and engineers in the world, where "best" includes quantity as well as quantity. And, if you have a problem with the English language, try Russian, because one of the big decision makers in Russia recently said that oil in that country will never exceed 10 mb/d. That sounds like a peak to me. even if he might be a little wrong. And if you have a problem with English and Russian, try Arabic, because despite what you hear about all the oil in the Middle East, you will be seeing some peaking there too, and according to some observers it will start in about a decade - if not sooner.

Finally, is it true that the whole can be greater than the sum of the parts where this topic is concerned?

2008 Dec 30 09:59 AM

[nestegger:]

The price of oil imploded because, after reading Black Gold by George Orwell, I bought four oil stocks. I plan to keep buying them.

2008 Dec 30 10:56 AM

[Alex Filonov:]

Saildog:

I know about supply and demand situation. I also know that size of the futures market exceeds real commodity market by more than an order of magnitude. Futures might reflect the actual price of oil. But they might as well ignore it. Who cares what 2-3% of market participants are doing? Long term, futures have to adjust to commodity supply and demand situation. Short term, we have what we have.

2008 Dec 30 11:32 AM

[Fabien Hug:]

Oil is cheap and whenever I can I buy some oil.

2008 Dec 30 11:47 AM

[Chris B:]

There is no method, guru analyst, data source, or common-sense reason that successfully predicted the price of oil throughout 2008. As it was, everybody was right at some point in the year and wrong in the end! The lesson we should learn is that oil investments are a crapshoot because of the inelastic supply and demand curves create a "chaos theory" effect that magnifies the effect of every one of the thousands of factors affecting oil markets. To think that now we can give some folksy explanation for why oil will sell between a particular price band is certainly gutsy. Have you sent your resume to Goldman Sachs?

2008 Dec 30 12:15 PM

[axelrod608:]

My crystal ball broke decades ago and I have no idea where oil prices will be at any specific date in the future. But I read extensively and oil is one of my favorites, and I have a background in geology and understand most of what I read.

There are 34 major oil fields in the world, 3/4 of which are in production decline, producing each year less than the year before. We can count on supply falling every year. Demand will fluctuate based largely on price. But the one fact that is absolutely crystal clear to me is that the world WILL keep burning oil in large quantities. Probably until the last drop is burned, because liquid hydrocarbons are good for a million purposes and are extremely easy to transport.

I'm taking this low priced oil opportunity to load up on dividend paying oil & gas stocks. In a year or two or five, they will become incredible profit machines paying big dividends while stock prices go ever higher. It's just a matter of time.

2008 Dec 30 05:00 PM

[nestegger:]

What's on your shopping list?


On Dec 30 05:00 PM axelrod608 wrote:

> My crystal ball broke decades ago and I have no idea where oil prices
> will be at any specific date in the future. But I read extensively
> and oil is one of my favorites, and I have a background in geology
> and understand most of what I read.
>
> There are 34 major oil fields in the world, 3/4 of which are in production
> decline, producing each year less than the year before. We can count
> on supply falling every year. Demand will fluctuate based largely
> on price. But the one fact that is absolutely crystal clear to me
> is that the world WILL keep burning oil in large quantities. Probably
> until the last drop is burned, because liquid hydrocarbons are good
> for a million purposes and are extremely easy to transport.
>
> I'm taking this low priced oil opportunity to load up on dividend
> paying oil & gas stocks. In a year or two or five, they will
> become incredible profit machines paying big dividends while stock
> prices go ever higher. It's just a matter of time.

2008 Dec 30 06:07 PM

[fatpitch2:]

Jimmy46:

I understand your point, and it is well taken, I appreciate it.
Two questions for you if you have time:

1) Clearly the "cash cost" of production varies considerably depending on the source; I would think that the middle east has the lowest cash costs while the Canadian oil sands might have some of the highest....???

Do you have any data on the cash costs for major producers?

2) If I were a producer and had cash cost less than current market price I would throttle production to the bare minimum that was required to cover my expenses and leave the rest in the ground for a better day and a higher price. Perhaps there are few producers with this much leeway, and they are all producing as much as they can in an attempt to cover expenses... ???
On the other hand, some producers having higher variable costs of production (oil sands?) might be able to more easily throttle production and still remain viable. Are there enough producers (any?) in the category to make a difference?

Thanks!





On Dec 29 05:39 PM jimmy46 wrote:

> Why does oil keep going down? Surely, at under $40, marginal producers
> should just stop production and wait until price is good enough for
> them.""&quot.....
>
> For some of the recent deep water projects, the TOTAL COST OF PRODUCTION
> may be $70 or more.
>
> But, most of that cost is upfront drilling for the oil,
> once production starts the CASH COST OF PRODUCTION is probably no
> higher than for shallow water oil.
>
> CASH COST is what drives the extraction industry in the short term,
>
> TOTAL COST is only used for deciding whether to START a new project.
>
>
> RESULT: NO ONE IS GOING TO HOLD PRODUCTION DOWN TILL PRICES GO HIGHER.
>

2008 Dec 30 06:21 PM

[BSG:]

All of you that think oil will put food on your table better think again. The genie is out of the bottle and GREEN will continue to put pressue on new developments. Your frined Bush bailing out the auto companies will start to nail the coffins on your industry. You are all a bunch of idiots guilty of treason against America!

2008 Dec 30 06:47 PM