Oil is sliding down the hog cycle with deteriorating fundamentals: the demand is pulling left and the supply is pushing right (Chart 1). Historical parallels imply oil is vulnerable (Chart 2). Implication: initiate a strategic short on oil and target WTI at $70.
Oil: hog cycle turned upside down
Back in 2005/06, economist Nouriel Roubini commented that oil market follows a hog cycle (see link), which would lead to a $100 oil. To quote Roubini:
Essentially, short-run inelastic supply and demand for oil and the delayed effect of high prices on new exploration, investment and production imply that spikes in demand (driven say by high global growth) do not lead, in the short run, to strong supply responses and thus prices spike. Similarly, supply shocks (due to geopolitics and other expected reductions in supply) can also spike prices in the presence of inelastic demand. Only persistently high prices will eventually lead to greater supply and, given inelastic demand, to sharp drops in prices once such supply increases. So, oil prices go through long cycles of high and low prices, a sort of boom and bust or "hog cycle" as this phenomenon - also known as a "cobweb-cycle" or "pig-cycle" - was first noted by economists in the market for hogs/pigs raised by farmers.
That was a great call. Fast forward to 2013, the hog continues to run, but the cycle has turned upside down (See Chart 3).
Oil fundamentals are deteriorating on both demand and supply, with the bulk of pressure coming from US and China.
Oil Supply: the next revolution to the right (See Chart 1)
Leonardo Maugeri at Harvard's Kennedy School has done a compelling study on the future of oil supply, which foresees a global glut at the end of this decade (see link). Figure 1 below taken from the paper summarizes their forecast.
Maugeri's arguments for oil glut:
- Historically, oil supply tends to be underestimated, which revises higher over time through better knowledge and technology (case: Kern River Field in California).
- Deconventionalization of oil supply and "The Unconventional Four": U.S. shale/tight oil, Canada tar sands, Venezuela extra-heavy oils and Brazil pre-salt oils.
- U.S. is leading a revolution capitalizing on its technology (horizontal drilling and hydraulic fracturing) and endowment (massive untouched shale/tight oil fields).
- Oil rush: worldwide oil exploration and production (E&P) investment totaled $1.6T from 2010 to 2012.
- 2015 is the point of no return: most oil projects will reach peak production by then and once started hard to stop.
- Oil price prerequisite for new production: $70, at which 80% of the new production will be profitable.
Oil demand: the new normal to the left (See Chart 1)
The "new normal" as described by Bill Gross combined with the still elevated oil price is bound to change the consumption behaviors. Seth Kleinman at Citi has done in-depth analyses along this line (See Citi's figure below).
Kleinman's arguments for slowing oil demand (see link):
- Increasing natural gas for oil
- Improving fuel economy
- Moderating Chinese appetite for oil
In the game of oil: U.S. and China
U.S. and China are two key players in this game of oil. Purely from the economic demand/supply perspective, the pair will jointly exert gravitational pull on oil price, as the above studies clearly demonstrate.
The U.S. oil revolution under way also carries geopolitical significance. Imagine the leverage U.S. gains when dealing with Iran if oil is trading at $50. Furthermore, oil self-sufficiency in U.S. pressures oil price further through improved external balances and the negative correlation between US$ and oil.
Meanwhile, China's Xi/Li are pursuing a new paradigm: lower quality growth (target 7.5% vs. 8% before as evidenced by the recent Q1 GDP). Social fairness and environment are climbing up Beijing's priority list for real. The US success illuminates a promising path to future energy security. Despite the obstacles, there is no doubt on where the Chinese will push (see link).
Pulling the trigger: learning from historical parallels (See Chart 2)
The above analyses lead straight to a strategic short on oil and next we consider the tactical aspects: the entry point, the price target and risk management.
As shown in Chart 2 and 3, there are three comparable hog cycles. To facilitate comparison, oil price is rebased to the local peak around the reversal point.
- Case 1: The Depression episode around 1930
- Case 2: The Oil crisis episode around 1980
- Case 3: The Sub-prime crisis episode around 2008
Acknowledging that each cycle has unique characteristics, we can still find the common pattern: first oil climbs persistently due to a demand (Case 1 and 3) and/or supply shock (Case 2); the elevated price eventually induces a sustained demand and/or supply response, culminating in a reversal of the cycle which usually involves a price collapse.
History does not simply repeat itself, but certainly rhymes. Chart 2 implies oil is reaching a precarious stage where a crash is a real possibility. The macro analyses here can't locate an exact breaking point, but they strongly argue for a strategic short right here right now. The fundamental arrow is pointing down, with a potential crash bonus.
The Harvard paper argues 2015 is a critical year for oil, when the bulk of new projects reach full potential. Since the market is forward looking in nature, oil price is vulnerable at any point between now and then.
A short oil position is exposed to many risks:
- global economy stronger than projected by "New Normal"
- geopolitical risks might flare up from time to time
- environmental concerns might slow down the U.S. oil revolution
- oil producers (esp. OPEC) preempt by cutting productions
Among them, the last is the most probable and powerful. However, the 1980s experience (Chart 4 from Wikipedia) shows that OPEC was outmaneuvered by the more eager non-OPEC producers. Today, we can plug in "The Unconventionals": U.S., Canada, and Brazil.
It is hard for a macro generalist to consider all the risk factors, esp. the oil-sector specific micro elements. Thus technicals are counted on for protection:
- Given the psychological significance of $100, we can use it for stop-loss.
- If a collapse does materialize, the 1986 experience indicates that any fall exceeding 40% warrants profit taking considerations.
- Otherwise, we target WTI at $70, which is the breakeven price for new oil projects.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.