Does Crude's Price Reflect Reality?

Includes: DBO, USO
by: Babak

While the crude oil market has sharply corrected from its bubble heights, there is reason to believe that it still does not truly reflect the underlying demand and supply equation at the heart of price discovery.

Here’s a chart showing OPEC’s spare capacity in millions of barrels over the past 8+ years:

OPEC spare capacity chart
Source: Bloomberg

We are right back to where we were at the beginning of the year in 2000 and 2002. Since this isn’t relative (to total production or demand) it is difficult to look at this data series over time. But assuming that 9 years isn’t that long, it is still valuable.

Of course, there are many variables that go into determining the price of a barrel: total capacity of production, how much oil is flowing from OPEC, how much demand there is from the global economy, as well as the demand from institutions not for use but for investment.

This last rationale has been the driving force in recent years as ‘animal spirits’ have taken hold. While last year’s crude oil bubble returned to normalcy, it looks like it is reflating right back up again. And the same basic script is being used as large institutions and hedge funds plow money back into this market.

Considering the extreme economic downturn, crude oil should have fallen to $20 - previous support from 2002. That’s just my own guess. Or it could have not gone up so much in the first place. Instead of acting as a ballast to rescue the global economy when it most needs it, it has instead been acting like an anchor, dragging it down further.

Here’s a chart of crude oil futures for the same time period showing each time that spare capacity reached above 6 million barrels:

crude oil futures OPEC excess capacity

Looking at these two charts together makes one wonder if the crude oil market is ignoring the excess spare capacity or whether it successfully discounts it. For example, most recently by falling from $147 in 2008 to less than $40 in early 2009 as spare capacity shot up to multi-year highs.

It is impossible to speak on behalf of a collective such as the market but my hunch is that, for the past few years, the oil market has been driven by tectonic shifts in asset allocation more than that which can be explained by fundamental analysis (such as supply and demand variables).

While we’re at this discussion, here’s an intriguing thought experiment. Imagine if instead of crude oil, we had to rely on a cartel such as OPEC in setting the price of a ubiquitous commodity like say, water. How would the price of water be set? would we just go along? or would we simply refuse to allow a cabal to dictate the price of water by turning their spigots on or off?