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)
