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.