What The Past Teaches Us About Oil Price Movements Now

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Includes: OIL, USO
by: Gary Bourgeault

Summary

How to think about how high or low oil will go.

Why this is different than cycles of the past.

This isn't going to play out like most investors think.

The catalyst now having most impact on the industry.

Click to enlarge

Source: Live Trading News.

If you've invested in or followed the market for enough time, you find out quickly it can continually surprise people as to expectations concerning price movements - whether up or down.

I'm not talking only about the volatility of the market, but the duration of upward or downward movements as well. This is one of the reasons attempting to time the market can be so detrimental to those thinking they're smart enough to do it.

Of course it has nothing to do with brain power, but more to do with the psychology of investors and how they interact with the market, many times based on emotion. That emotion is what can exasperate many investors because they base decisions on the best accumulated data and the analyzing of it. The best investors are able to subdue their emotions and bypass the temptation to be influenced by the herd.

The problem with the herd is they are the ones that make it hard to predict market movements in the short term because they don't act rationally; they take action based on emotion.

In a similar way, this is true of oil, as the market catches wind of some type of cycle or disruption, and rather than analyze it thoroughly, buy or sell on headlines in the news or talking heads reiterating what the herd is doing. It can create a stampede in whatever direction the momentum is going at the time.

The price movement of oil

Many investors knew a correction was far overdue for the stock market, and that has come quickly and hard. What wasn't known at the time was when it would happen.

This is an important part of understanding market movements in general, and oil price movements in particular. One thing experienced investors know, but yet still need to be reminded of, is a market or commodity can appear to have everything lined up for a downturn or upturn, but historically the current momentum can last much longer than the data justify. Again, this is a major reason market timing rarely works. It's hard to turn the herd in another direction. It takes time for new data to be absorbed and taken into account. In the meantime, momentum continues to be driven by emotion.

As it relates to oil, this is what is happening now. The price remained much higher and stronger for a long period of time than was expected by a lot of analysts and investors, as the realization there was a lot more supply in the market than demand warranted hadn't sunk into many investors heads.

This is why many times markets can continue to drive up higher or plunge lower for longer periods of time than many think they can.

I believe we're now in such a time for oil. Even if the fundamentals change to the better - which I don't believe is going to happen for at least a year, and probably longer - we're not going to see some major reversal in the price movement, meaning it's not going to suddenly skyrocket to high levels.

What I'm suggesting is this is being driven by emotion (although based on real data). The oil market is extremely skittish at this time, and while there will be some upward movement at times, investors will quickly exit once they make some quick money. The inevitable retreat and pullback in prices will soon follow.

It looks like we're going to be in for a time of prolonged downward price pressure on oil. This could last much longer than expected.

Cycle or disruption?

Reading a lot of what investors and analysts are saying about oil, I think the reason there is so much confusion and uncertainty is it is being treated as a cycle as have occurred in the past, when in my view it's not a cycle, but a total disruption of the oil market because of the emergence and growth of shale oil.

Another thing that may be confusing the market is we might be experiencing a cycle layered over the disruption, which includes combined variables not usually experienced when analyzing oil.

This is important to understand because this oil market isn't acting in the way it has in the past, and competitors are taking steps that are unprecedented in response to the market. This in itself is enough to confirm something is happening now that is different than has happened before.

Among those responses are those from Saudi Arabia, which has resulted in steps being taken to shrink its exposure to various programs it had in the pipeline, as well as get rid of some non-essential programs. There are numerous other things it's doing to reduce its risk in a low-price oil environment. These are steps pointing to the belief there is a disruption, not simply another cycle the oil market is going through.

The shale disruption

There are a couple of things to consider with the shale disruption. First is the shale oil itself, and second, the way shale oil can be positioned to be produced.

What is most important over the long term is the fact there is a huge resource of oil that can be introduced into the market for many years. After analyzing the plays, it has been found there is about 419 billion barrels of recoverable shale oil in the world. The U.S., which is basically the only real producer at this time, accounts for between 70 and 80 billion barrels. Russia is in that range as well.

As exploration continues, we'll find a lot more shale oil than that, as evidenced by a recent discovery of a lot more in Argentina.

The methodology used to determine the amount of shale outside the U.S. is to take the amount of oil in shale formations in American and use that data to make estimates on similar formations in other parts of the world.

With the U.S. alone, shale has resulted in the ability of the country to produce about 10 million barrels per day. That places it up there with Saudi Arabia and Russia. Those numbers will remain lower until the time when the price of oil rebounds. I'm only talking about potential here, not whether companies will take action to reach that potential under current price conditions.

It can't be underestimated as to how disruptive this is to the market, and this is with only the U.S. competing at meaningful levels. Think of what will happen when shale oil starts supplying the market on a global basis.

Not understanding the depth of the impact of shale oil on the market is what is confusing many investors in analysts. It has messed up the models they used in the past to understand the market, and many are still analyzing the market without taking into consideration the short- and long-term impact shale will have on the price of oil.

As I've mentioned a number of times, the other unique feature of shale oil is companies can develop wells but not complete them (DUC wells), waiting for the best time to bring supply to market. This will have an impact on the mid and upper levels price of oil, which is the other major disruptive force emerging from shale.

In the past, OPEC could simply make a decision to decrease or increase supply and move the price. It no longer has that ability across the oil price spectrum. Now it only has control of the lower price points, which it has been enforcing with its ongoing oversupplying of the market.

How this will play out

If this is a disruption and not only a cycle, what does it mean for the oil industry? The important element is how it disrupts supply and demand, and by extension, the price of oil.

One remaining factor that is unknown is how much demand for oil will rise. China has already been downwardly revised on oil demand for 2016, and that's in a low-price environment. Weak economies are another element that has to be considered, and globally there are numerous countries in recessions or flirting with them. This very easily could lower oil demand if there is a lot less money for consumers to spend, as well as less capital available for government spending.

Combined with the shale disruption, this could get a lot worse before it gets better. I think global demand estimates and assumptions are too high, and if I'm right, this will eventually weigh further on the price of oil as it becomes more visible.

In my view we're still too early in the shale revolution to know how it will inevitably have an impact on the price of oil. That said, the price will be much lower than in the recent past, where it soared to well above $100 per barrel. Barring a geopolitical situation, I don't think we'll see that again for many years. When we do, it would have to include a robust global economy that has a significant increase in demand for oil.

That isn't going to happen for some time, and over the next couple of years, the price of oil will probably not reach some of the levels being suggested. This assumes no agreement to lower supply between competitors.

With Iran about to increase exports, I don't see an agreement as being something based in reality anytime soon.

In the short term there are hundreds of DUC wells in the U.S. ready to be brought into production in response to any upward price movement. The additional supply will keep the price of oil low if there are cuts in production from other competitors.

Conclusion

Just because the price of oil has plunged quickly and deeply doesn't mean it can't remain there for a long time. The stock market has historically experienced many periods where an upward or downward move lasted much longer and moved higher or lower than the market anticipated. I think we may be see that with oil; this time on the low side of the price.

Considering this simply another cycle for oil is a mistake. This is a complete disruption of the oil industry. It's a discontinuity that has immediate and long term consequences for investors and energy companies.

If we've learned anything from the past, periods of market and price swings can last much longer than believed because of momentum driven by emotion. Legitimate changes and data drive the initial movement, which is then embraced by the herd, which can result in overselling the market or commodity.

There is some of that going on now. But this is based upon solid data and market realities that justify much of the reaction to them and the price movement.

For these reasons, we shouldn't assume just because the price of oil has been battered, it won't stay down for a significant period of time.

Disclosure: I/we 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.