Crude oil price has followed our projected price curve in 2011 reasonably tightly, rising to its highest level of US$110 per barrel by the middle of year and then plunging to US$78 per barrel by the end of Q3 2011. This high volatility was caused by changing expectations setting the stage for negative / positive economic surprises. WTI-based contango largely flattened in 2011, making investing in instruments like USO profitable, which adds to marginal funds flow in crude oil speculative positions (paper barrels of oil). The crude oil price has displayed a strong correlation with other asset classes in general and equity markets in particular and has led the equity markets since the summer of 2008. Today’s three main investment worries are weakness in US economic fundamentals, the euro debt crisis and weakness in China Inc. We are currently hitting a crossroads on the global economic outlook and sentiment is quickly shifting from overtly bearish to overtly bullish. This has made it necessary to look into the crude oil market fundamentals in much more detail to forecast a forward price. The main issues relating to crude oil are;
- Average Level of Crude Oil Price in 2012 & Q4 2012
- The ceiling and floor of crude oil price in 2012
- Average volatility of crude oil price in 2012
- Timing the reversals of crude oil price
- Crude oil refining margin (crack spread)
- Direction of spread between Brent and WTI
- Correlation of crud oil price performance to other asset classes
2012 Oil Price Forecast:
Based on a slew of forecasting tools (some of which are used by EIA, OPEC etc) including global macro multifactor oil price model (Forecasted price at US$86 per barrel), risk premium/discount model, crude oil/energy substitution model (forecasted price at US$89 per barrel), spare production sensitivity model (Forecasted price of US$82 per barrel), historical trend statistical probability model, fund flow model, we have arrived at short (Q4 2011) and long term crude oil price (2012). We still see US$84 per barrel as goldilocks price which supports the market without impeding the economic recovery.
We expect the crude oil price to average US $86/barrel in Q4 2011 with an average price volatility of 20% with a slight skew of 10% towards downside. This implies an upper bound of US $91/barrel and a lower bound of US $75/barrel. The crude oil price is not expected to slide down like it did in 2008 as the 2008 collapse was driven by a combination of margins calls driven by managed money-forced liquidations and extreme fear.
The recent rebound in crude oil price was warranted as managed money longs and shorts had veered off from their recent mean level by more than one standard deviation. Short term ebb and flow of investment money/paper barrels and asset relatives will keep determining the short term crude oil price.
Another way to look at the fear/growth paradigm is check out the gold to oil ratio, commonly known as GO ratio (currently at 18.83 – has come down from 20.5 in September). This is one of the common indicators watched by the traders of both commodities. It has strayed 1 standard deviation away from its long term average (14.43), despite a drop in gold price to US$1660s. A mean reversion with current gold price implies a crude oil price north of US$90 per barrel.
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Estimated flux in technical indicators may be helpful in short term market timing efforts. Overall, the crude oil market will be flat and oscillating in 2012 with a crude oil price average of US$ 86/barrel but with an increased volatility in 2012. In H1 2012, the price of crude oil may average around US $84 / barrel as supply constraints may ease, some renewed challenges to global demand may emerge from Europe, China against a backdrop of higher expectations built up to year end 2011.
Crude oil may rise to US$88 per barrel in H2 2012 on improvement in economic data, drawdown on inventories, and drop in US dollar strength. The correlation with global / emerging equity markets may stay high and crude oil may keep its role as a leading indicator of equity markets. By the end of 2011 crude oil implied volatility will increase as the market may put a price discount on the normalized price level (US$84 per barrel). Fundamentally, despite forecasting only a modest GDP growth, an increase in energy efficiency of GDP as crude oil consumption per GDP dollar declines, crude oil as a percentage of energy consumption declines for US & EU, remains constant for Japan & China (crude oil remains at 12% of energy consumption) (remains a coal based economy), may result in increase of crude oil demand to 88.8 million barrels per day, which should put a floor under crude oil price.
Trading Suggestions & Ideas:
- Brent price may average US$101 per barrel in 2012 – which keeps GCC selling price well above their breakeven crude oil price – so strategic O/W on GCC (Saudi / Qatar)
- Brent futures will be firmly back warded and WTI will also tilt long end down which will make USO a profitable investment vehicle because of positive roll yield.
- Timing trades will outperform the secular trades in 2012 – as sentiment will fluctuate Best alpha generative equity long trade for 2012 will be buying on dips and selling on bumps of crude oil price (crude oil price as selling the equities).
- Best trade ideas may relate to contracting spread between Brent and WTI.
- Best energy complex trade idea in Q4 2011 is to bet on increase of refining margins from current of US$7.4 to US$10 per barrel by Q1 2012.
- Crude oil price will have a strong correlation to the equity markets (>0.6) and may serve as a lead for inflection points.
Disclosure: I am long UGA.