Is Oil Going the Wrong Way, Or Do We Need to Adjust Our Perceptions? 19 comments
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It's high time to write a comprehensive post on recent oil price movement. Since my last post on April 16, WTI crude has gone up from $49.97 to $64.40 as of the time of writing, which is a 29% jump in a month and a half.
I must confess that it's been quite painful to watch even though that I have considered the possibility of such a scenario suggesting that oil could rise to $60, but such a move would make it the perfect short idea at that time. I now have to admit that my confidence has gone down a lot since then, and I don't think shorting oil now is the best idea. This could be just another example of how psychology makes us imperfect investors, and instead of acting we cowardly decide to change our view. Robert Shiller in his insightful "Irrational Exuberance' described the phenomenon of bubbles when rising prices attract more and more people, causing prices to climb even higher which, in turn, suck in more people and so on. I may well be following this false rout.
On the other hand, a group of scientists have discovered that taking a decision contrary to a consensus view causes reaction in your brain which is similar to physical pain. In other words, each time you act as contrarian you are almost breaking your arm. So, it could also be that I am just a bad contrarian investor and just one of many suckers out there. Without spending too much time on my personality, even though an investment diary is probably a good place for such reflections, let me present two ways of how one could try to understand this current oil price and act accordingly.
The first approach is simply the collection of arguments stolen from the camps of bulls and bears. Thoroughly going through the list of arguments of each side, it could be helpful to make a final decision of whether the oil price has overshot, reached some equilibrium or is on its way to a higher level. Obviously, the importance and weight assigned to each of the argument would be a personal matter for every individual. The second way of looking at this oil price is by developing different scenarios for future economic path (and thus the demand/supply situation), estimating potential equilibrium price in each scenario and then assigning probability for each scenario. You could then calculate probability-weighted price and compare it to current price. The difference between the two should help you make an investment decision.
Let me first provide a summary of both bulls and bears on the future oil price.
BULLS' ARGUMENTS:
1. Economy is recovering (whether for real or just in one's imagination there has been a growing number of people pointing to a few data points suggesting US economy is hitting the bottom and recovery could start in Q3 or Q4 of this year);
2. Inflation, if not hyperinflation, is a real probability and oil, as any other physical commodity of limited supply, should provide a great inflation hedge;
3. Fed's aggressive policy, partially followed by other Central banks around the world, could lead to a complete chaos in global monetary policy. The end of fiat money is approaching, commodities is what can save investor's wealth.
4. Chinese oil imports has been growing which is in line with its policy of converting part of its massive FX reserves into physical commodities. Besides, demand from other Emerging markets including China is set to rise as standards of leaving there shift from ultra-poor to closer to middle cars (which implies more electricity, cars etc.)
5. On the supply side, bulls are talking about OPEC policy of taking off around 4m of barrels from the market, much higher discipline among its members this time than before and also about massive E&P cuts undertaken by independent producers which should limit supply
6. Another bullish argument from the supply side is the so called 'Peak Oil' theory highlighting the fact the world is quickly approaching a period when oil production will start falling due to lack of new fields, exhaustion of old fields with rapidly growing demand.
7. Technically, as the price is making new highs it should keep climbing further. So, breaking $60 for the first time this year oil price is deemed to reach $70.
8. There was evidence from some of industrial consumers that they started hedging their oil exposure suggesting wider market players are expecting oil to go higher.
9. ETFs providing commodity exposure have seen significant inflows of new money recently, which is adding upwards pressure on the oil price.
BEARS' ARGUMENTS:
1. Its too early to tell that economy is really on its way to recovery. One can find a few negative data points mainly in labor market and bankruptcy rates. Positive changes in some of the leading
indicators could be just the effect of a low base. You cannot expect them to keep falling all the time, but random jumps are no guarantee that the trend has changed. Also, even if the economy is recovering responding to an aggressive government policy, the cure is worse than the decease (or basically the same - you cannot drink yourself sober). Adding more debt to the system (even if comes at the different level this time) is not fixing the fundamental issue of too high level of debt among US consumers and global banks.
2. Its easy to see more troubles ahead: some US states are on the brink (e.g. California), a wide group of companies and financial intermediaries like private equity funds are overstretched with debt (their bankruptcies could lead to some nasty consequences for the global economy), some states in Eastern Europe and Latin America are severely sick too. The most recent negative issue is coming from Treasury market, with long-term yields reaching Nov 08 level before any QE action was in sight. Mortgage rates have started to grow in response.
3. Some argue its still deflationary environment out there. Consumers, banks, companies, HFs/PEs need to de-lever further. This should lead to contraction of money in the system and hence lower asset prices.
4. With current oil production level, marginal cost of production which should determine equilibrium price is around $40.
5. Too rapid oil price advance would prevent economy from normal recovery and this would lead to another massive price correction. There are estimates that oil price correction has provided a net effect of around of $1.6 trillion for the world economy, which is almost 50% more than collective actions of Central banks around the world.
6. Evidence from physical traders suggests there is still a lot of oil overhang. Inventories are rising worldwide (with the exception of US market in the last three weeks). Add to this 50-60 oil tankers that have been hired by traders to store oil (that is another about 100mn bbl assuming one tanker can take 2mn bbl).
7. Besides, almost each of bullish arguments provided below could easily find a counter-argument from any bear. For example, OPEC discipline seems to be vanishing - the Cartel has recorded rise in production in April (Iran and Venezuela are cheating). Expect more cheating ahead as their budgets are in trouble and with rising oil price its much easier to implement. Chinese oil imports is quite small compared to global oil demand. 'Peal oil' theory is only relevant in a static world. In a dynamic system, new technologies lead to higher energy efficiency and new sources of energy should help to avoid oil price breaking record levels of $200 or higher. Technical analysis is rarely helpful especially in identifying long-term trends.
While I find arguments of bears more plausible, there are couple of points which make me more willing to join the camp of the bulls. First point is that the market can stay irrational longer than you can stay solvent. Even if fundamentally oil market remains weak, just because too many people believe economy is recovering can prevent oil prices from correction for quite a while (or even grow to much higher levels). Second point is that you should never fight the Fed. If it decided to print money madly by way of purchasing Treasuries and MBS papers, just pure increase in paper money will lead to higher prices for any goods whose quantity is limited.
Now, I would like to explain my second approach to assessing the situation in the oil market before making final conclusion. In the second approach, I have identified five main scenarios which I find possible for the world economy and the oil price.
Scenario 1. Global deflation, Oil price around $20, probability - 15%
Scenario 2. L-shaped recovery, after hitting bottom global economy to remain weak for a few years ahead, Oil price around $40, probability - 20%
Scenario 3. U-shaped recovery with slow rise in economic growth, Both Developed countries and Emerging Markets experiencing deflation, Oil price around $50, probability - 25%
Scenario 4. U-shaped recovery (as in Scenario 3), but while Developed countries face deflation, there is inflation pressure in Emerging markets (mainly due to successful domestic demand stimulus in China) causing modest global inflation, Oil price around $70, probability - 30%
Scenario 5. V-shaped recovery, with US and global economies returning to growth in autumn of this year, Oil price at $100 or higher, probability - 10%.
Obviously, the weights are crucial in such approach and I appreciate any inputs here. These weights are mine with consideration of experts' views. Oil price in each scenario is also debatable. Now, this analysis gives an average price of $50. Current price suggests that market is thinking the world will face higher inflation either because US will be printing too much or Chinese demand will add to it or just because we are back on our way to economic growth (Scenario 5). Personally, I am less convinced in probabilities for Scenario 4. Should it be lower, than obviously there is room for some oil price correction of around 20%.
Having done both types of analysis I have to conclude that mainly tactically my call to short oil in April was most likely wrong. I would not recommend shorting it now, mainly because of the bigger than I initially expected role of sentiment. The best way to position yourself for the next several months is just to add some commodities to your portfolio on the pullbacks. I am long gold for example. I would add some agriculture at good levels (have not identified them). And for sure I would add oil if it ever falls to $30 but only taking a long-term view.
Disclosure: Long SOIL LN (Short Crude Oil ETF)
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That thing gets 14 mpg highway and she was content to sit in it on the phone with engine running waiting for a latte.
Long USO
Dealerships are closing, car factories are idled, parts suppliers are fleeing for bankruptcy protection, the cars that are getting sold are getting more miles per gallon, so fewer people are driving fewer miles or getting more miles per tank so they aren't filling up as much, so this means a boon to oil producers?
I haven't heard a peep about the financial impact of this past Memorial day weekend (where people usually travel to visit relatives or gravesides) so I'm guessing that alot of people who had the opportunity chose to stay close to home, if they left the house at all, so this means a boon to oil producers?
Consumers aren't buying gasoline, and drivers aren't delivering as much as they were so they're not buying diesel. Even with the refineries that have shut down this year, and the ethanol producers that have gone out of business this year, and the number of explorations/development of new crude sources dropping like a rock, prices are going up on a commodity that (it seems to me) isn't exactly flying out of the stations. So where is all of this oil going? Who is buying it? Where are they storiing it? Who is refining it? Or is this yet another Ponzi scheme?
1. Peak Oil
2. Supply Destruction when oil is sub-50
3. Foreign Demand will far eclipse any decline in US demand
4. Falling dollar
Of course I am not betting the farm (already lost it), but a could chunk of change.
-Also, I don't think there is a unified global movement or shape to the recovery; China, the Mideast, Canada (at least) seem to be on the road to a V shaped recovery, while "old" Europe may be slower and "new" Europe and the non-OECD a lot slower, if at all.
-There is also the "Vacuum Theory" (newly named but probably not new in itself) that say that SOMETHING has to lead the markets if we are going to recover. (Notice the conversation is not if, but when, a huge psychological difference from the massive doom and gloom when the banks were teetering a few months ago). If the market leader is not housing, not durable goods, not consumer discretionary spending, not dot.com - what is it? Uh, how about commodities!! Clearly, almost everyone thinks that commodities will do well in a recovery and since we are closer to recovering, people who are buying are buying commodities. Is this speculation? Not if you are in at $33 BOE (March).
-The question, as always, is whether we are now early or late. The oldest adage of don't fight the tape may likely now apply. Until there is a change in leadership away from commodities there will not be a change of leadership away from commodities. Many energies have gotten killed and are selling at historically low P/Es, even though they've doubled in the last couple of months. (For example, the Canroys). Prudence suggests being long with reasonable stops. There doesn't seem to be anything in the way right now.
Perhaps that's the best reason of all to go short. ;-)
1) Increase production - producers can get more $$ from the higher price
2) Decrease consumption - consumers will buy only as much as they absolutely need
This is a recipe for another crash. Beware of investors killing their own investment.
If you're torn between the bear and the bull arguments, probably the best thing to do is to stay out of it altogether.
"You forgot the one thing that may actually be moving prices, namely the destruction of the US dollar. The dollar is getting killed vs. the $CDN, Euro, etc. "
I think he's right.
Since oil is priced in dollars the weakening dollar is probably responsible for the lions share of this spike.
Since I believe the dollar is going to continue to weaken I believe oil will go up. That which might strengthen the dollar might scare oil up, ( ie attack by Isreal on Iran, terrorist attack on major city, use your imagination) I think there would be a flight to safety (least ugly) and dollar would benefit but so would oil.
Long oil seems logical.
Of course the declining USD will boost the $ price.
There is also a significant reluctance in producing countries to see their oil exported cheaply, especially if payment is made in declining dollars. They may as well keep it for their own development.
The major fields are declining in production and any new production or technology is going to be significantly more expensive. Wind and solar power are ephemeral while nuclear is still far out on the horizon.
It's impossible to predict the price tomorrow but, for the forseeable future, the direction is up.
what lexus GX470 (image is all) drivers do is irrelevant to the real world.
> jack
Maybe inflation is not just a 'real probability" but here already.
Where is this information available? Did this contribute to the $147/bbl bubble? Is this enough to create this bubble?
Stimulus package creates demand, which increases crude prices to the point that the increased energy costs offset the value of the stimulus package....
The energy markets are all over the idea that CL is going to $75/bbl; seems no one has factored in that the return to higher prices will force the US into a stagflation scenario, meaning very low growth in GNP and a flattening of demand.
re Iran and Israel I've been to Iran a few times, and recently have met ministers, heads of state corporations, leading parliamentarians and even the top cleric re Sharia'h compliant finance.
Iran is as much a theocracy now as Russia was Communist under Gorbachev ie virtually not at all. It's the Iranian Revolutionary Guards who have the monopoly on beer imports from Turkey.
And even if what President Ahmadinejad said implied what the Israelis say it does - which I am not enough of a Farsi scholar to judge, but doubt - it really does not matter, because he has very little power.
The one thing I can say from personal experience is that these guys are pretty shrewd negotiators, and there is no way they would give up their strongest card - ie the perception that they are manufacturing nukes - away cheaply.
What should worry the US - and I think it does - is the fact that Pakistan, which has 100 nukes, is a disaster zone. Iran is keenly aware of this, because Pakistan is a next door neighbour. So the US has far more in common with Iran than they do differences. Israel should reappraise their strategy, because the game has changed.