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Because oil is a consumable (flow), mainstream thinking is that its price, even more so than that of gold which is a stock, is subject to supply and demand, fear, greed and manipulation. The author is not aware of any public domain models of high empirical significance, let alone theoretical substance. Those that exist seem to be based on historical scenario projection, supply and demand trends, world GDP and “peak oil” calls without specific rationale and mathematical specification. Macro models (good overview at this link) are really multi-variable regressions of macro variables to the price of oil. No other theory has derived the price of oil in terms of the same axiomatic valuation principles that have been shown to value stocks, bonds, and gold.

Required Yield Theory provides this WTI USD$ oil valuation model with an absolute variance of 15% spanning the last 13 years of high volatility.


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As a frame of reference, consider how well EIA forecasts performed:


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The poor forecasting record calls into question the underlying theory for and mechanism of oil valuation that is in use today by even the most sophisticated specialists. I do not intend to directly compare an explanatory model to a forecasting model, though they are two sides of the same coin. Rather, I do want to point out that the correct explanatory model enables much more accurate forecasts based on specific evolving scenarios.

A Theory and Model of the Valuation of Oil

Just as Required Yield Theory (RYT) asserts that the value of gold is determined by its relationship to world GDP vs. the relationship of fiat currency to GDP – an effective exchange rate of relative values; so too RYT asserts that the price of oil is a function of the relationship of oil to world GDP vs.. that of fiat currency. Oil enables a stream of productivity like a new tool or technology. That productivity stream is essentially constant as evidenced by the growth of oil consumption mirroring world population growth leaving per capita consumption/oil-related productivity constant. (While the flow of oil per capita is constant, the stock of gold per capita is constant) Until cost-effective, pervasive, safe and ecologically sound alternatives for oil are found and enabled to widely replace its role in materials/plastics, fuel, cosmetics, pharmaceuticals and lubricants, oil will continue to fulfill this role.

Just as the introduction of the plow raised farm productivity by a quantum amount, oil has done the same thing through many product and functional forms. The price of the plow was set according to the real productivity gain that it enabled. Likewise oil.

The real price of something enabling a constant real incremental stream of productivity would be constant, all other factors not changing; like a perpetuity returning a constant real stream of purchasing power valued at a $1 today at a required real return of 2% would be valued at $50 as long as it performed this role and the purchasing power of the currency it is priced in doesn’t change.

Fiat currency inflation: world inflation would correspondingly impact the price of oil so as to maintain its real price constant.

Exchange Rates: the local, e.g. USD$ price of oil would be inversely impacted by the GDP-weighted exchange rate to the extent that the rate is impacted by factors other than inflation differentials which are already accounted for above.

World Productivity: world real per capita productivity growth variations in relation to the long term trend of about 2% would correspondingly affect the price of oil as it participates in earning an abnormal rate of productivity growth.

The Fiat Asset Real Rate of Interest/Expected Return: because oil provides a constant real productivity stream, the change in market real yields in relation to the long term real yield inversely impacts the price of oil. E.g. whereas a long bond real yield may be low, the constant real yield of a barrel of oil would be priced correspondingly higher as fiat asset real yields/expected returns fall.

Supply/Demand: the gap between supply and demand in relation to readily deployable spare capacity is the final major factor in the RYT model.

Data Elements

  • IMF World GDP Forecast; world population
  • IMF World Inflation Forecast; Actual Inflation Rate
  • IEA, EIA and other estimates of spare global rapid deployment production capacity
  • IEA, EIA global demand, supply forecasts and estimates
  • Treasury yields across the term spectrum
  • TIPS yields
  • Blue Chip Inflation Rate Forecast
  • U.S. Exchange Rate: DXY and related measures

The Model

The RYT model is patent-pending, unpublished, and available selectively to investors pursuant to a NDA.

Conclusion

Oil valuation, like that of stocks and gold, is driven by a principles which theoretically and empirically account for the vast majority of price and price volatility; leaving little room for bit character roles for emotions, hedging, speculation or “manipulation.”

Current valuation of oil contains a sizable premium for supply disruption i.e. U.S./EU-Iran tensions. Absent further escalation, it is very vulnerable to downward world growth estimate revisions and somewhat less so supported by the lower real fiat asset yields that would come with lower expected growth. Lower growth projections, if forthcoming as this author expects, would be very negative for oil and for the economies and stock markets of oil producers such as Russia, UAE and parts of Latin America and Canada.

Given the precarious state of the world economy, escalation of tensions with major oil producers is likely to be limited since politicians know that a spike in the price of oil would be devastating to Western economies. Conversely, any growth surprises to the upside will both drive oil prices higher and provide political cover for more robust sanctions against Iran which will compound oil price spikes.

The novelty of the RYT formula is that it directly links the valuation of stock markets, bonds, gold and oil to common principles anchored on a constant: the long run global real per capita productivity growth rate of about 2-2.1%. It computes the price of oil based on specific theoretical premises and associated formulas for each variable. It does not use regressions or any other form of retrofitting of dependent and independent variables to each other. Such models are very subject to shock in future vs.. past relationships of these variables and do not offer substantive causality arguments.

As a footnote, the Angry Bear blog showed this chart of interest some time ago which evidences the powerful link between the price of oil and its relationship to GDP expressed through its share of imports to nominal GDP.

Intellectual Property Notice

Required Yield Theory ™ and RYT ™ are trademarks. Required Yield Theory is patented in the U.S. under two patents (US #7,725,374, and allowed Serial No. 12/766,956); is also patent pending under several applications; and patent-pending in the EU and other political jurisdictions. Public domain formulas may not be used in computer applications without license from the author. Asset managers wishing to learn about the applications for gold, stock, bond and oil valuation may contact the author through RYT. Formulae and data will be provided under NDA for evaluation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.