This post will explore a bit of basic economic logic, which appears to be escaping the grasp of many energy analysts lately. Not all are making this mistake, but enough are that I figured I would write an article to clarify this train of reasoning.
I continue to read many analyst reports, which go something along the lines of this:
"… Therefore, because we expect the glut in oil supply to persist over the following 6-12 months, we expect the price of oil to continue to trend downwards in the near-to-intermediate-term future."
Or:
"We expect that the recent uptick in oil prices is only temporary, a so-called 'dead cat bounce' due to the fact that we foresee the oil glut persisting for some time into the future."
Now it may be true that the current uptick in oil prices is merely a dead cat bounce, poised to continue the downward trend of recent months. If you want a crystal ball prognosticator to solve this mystery for you, however, you won't find him here. But, crucially, if oil prices continue their downward trend it will not (simply) be because of the continued glut in the supply of oil.
What will determine the movement in the market price for oil (barring any extraneous shocks) will be the answer to this fundamental and all-important question:
Is the magnitude of the collapse in the oil market price justified by the magnitude of the glut in oil supply?
Obviously, the fact that there is too much supply in oil relative to demand does not mean that the price of oil ought to go to zero. Rather, there exists some (continually shifting) equilibrium market price whereby the magnitude and duration of the glut in the supply of oil has been properly reflected in the market price for oil.
A ~2% glut in oil supply has led to a very rapid ~60% collapse in the price of crude oil. Despite there being a persistent glut in supply, which very well could exist for the next 6-12 months or longer, is it not at least possible that the approximate 60% collapse in the price of oil has been an overcorrection?
At the present moment, there is too large an emphasis placed on the immediate and near-term production, demand, and storage figures regarding oil. But the current equilibrium price of oil is not only a function of the near term - today's equilibrium price of oil is the price of oil which, having been adjusted for the possibility and extent of demand and supply shocks, will lead the oil market to rebalance itself over the longer term (say 12-18 months).
If the market price has overcorrected in response to the supply glut, then the supply glut could continue for another 6-12 months while the market price trends upwards - to the bewilderment of investors and analysts who fail to understand this simple truth.
Additional disclosure: I am not a qualified financial professional. The opinions expressed in the article and comments section are not investment advice. Please do your own research and follow your own due diligence practices and contact a financial adviser before making any investment decisions.
