BubbleOmics: 10-Year Oil Price Prediction

by: Andrew Butter

“Prediction is extremely difficult, especially about the future” -- Niels Bohr

Once upon a time, everything was predictable. Rating agencies could “almost” guarantee negligible default rates on bonds bearing pretty AAA investment-grade stickers. And as the free world slumbered, Nobel Prize-winning economists fiddled with (fiendishly) clever theories like Inflation Targeting and the Black–Scholes model, which (theoretically) were going to create immense wealth out of thin air.

But sadly a “flaw” was found (more than one, actually), and the predictions didn’t work out quite as planned. Sigh!

All the same, my niece (aged six) can predict where the sun will come up and also where it will go down, with extraordinary precision.

So oil prices shouldn’t be too hard … right?

The price of oil “ought” to depend on three things: Supply, demand, and the extent to which the market is manipulated (bubbles).

Short term, supply is not very elastic; neither is demand. But one thing no one can dispute is that from time to time the market is subject to manipulation by both buyers and sellers.

That’s what H.H. Prince Turki Al Faisal Al Saud was talking about the other day when he declared that Saudi Arabia is committed to playing its part in facilitating recovery of the world economy, by making sure that oil is sold at a “fair price."

Well, that’s dandy, isn’t it? He didn’t elaborate on how Saudi Arabia had transformed itself from what the western media once used to characterize as an “economic terrorist" to a “fairy godmother of last resort." But what he was saying was clear: The Saudis will manipulate the market to bring the price down if they think it’s not “fair." That’s manipulation just as much as when they acted as “swing producer” in the 1980s to keep the price high.

So price is easy to predict, the Saudis say $70 to $80 is “fair,” and therefore that’s what the price will be.

That wasn’t so hard!

But then ... is that really the “right” price?

Big Idea

How about if, “fundamentally," the total amount of money that "the whole world” can afford to pay for oil is a constant percentage of GDP, and over the long term that’s what they will pay, regardless of how much oil they get?

That’s not exactly Adam Smith. But imagine if, suddenly, there was no oil (GDP as we know it would head in the direction of zero), and the Saudis magically turned on the taps and the amount of oil consumed was double what it is today, at half the price? (GDP wouldn’t double.) So perhaps, somewhere between those two extremes, there is an optimal?

Another term for that idea is “Parasite Economics." In the language of economists, that “theory” says the “Fundamental” price Of Oil Today (which I shall call “FOOT”) is equal to the Total Of All the world's GDP today (“TOAD”), multiplied by 3.33%, and divided by the amount of Oil Konsumed (yes, spelled with a “k”), which I shall call “OIK."

“FOOT” = “TOAD” multiplied by “3.33%”” divided by “OIK”

Crazy theory, eh?

If that’s right, then if you plot the “model” against the reality, there will be a “correlation,” which won’t necessarily prove it's right, but will at least prove it might be right. If there isn’t a decent correlation, then that’s proof the theory can be put on the scrap-heap, like those other theories from “once-upon-a-time” which had “flaws."

According to this convoluted line of reasoning (the “theory"), the red line on the chart is the “fundamental."

As you can see, it’s not a very good predictor of the black line (the actual price of oil); in fact, year-on-year it only explains 62% of changes in the oil price since 1970.

Put another way, 95% of the time it predicts the price of oil with an accuracy of plus or minus 75% -- which is not much better than a blind chimpanzee with a dart board.

So much for that theory!

If my niece could only predict where the sun would come up with an accuracy of plus or minus 75%, then 95% of the time (and a lot worse than that for the remaining 5% of the time) ... well, we would be tempted to feed her Ritalin.

Except for one thing:

BubbleOmics

One reason that the fundamental (“FOOT”) might not have predicted the oil price very accurately over the past 40 years is that the price of oil might have been manipulated from time to time.

Horror … now you tell me! That is preposterous … what about the cast-in-stone theory of “Efficient Market Hypothesis” -- the one that says markets never lie? Could anyone in their right mind really be proposing that the fundamental assumption that lies at the bedrock of our sacred economic universe has got a flaw?

Uh-huh.

Like in, “Assumption is the mother of all Frappuccinos."

Bubbles

What happens when markets are manipulated upwards (by whatever means) is that you can get a “bubble,” which is where the price ends up -- a lot more than the fundamental. The next thing that happens is that there are “mal-investments” that only make sense at “bubble prices."

Then the bubble pops, and since bubbles are zero-sum, the next thing that has to happen is that prices have to stay much lower than the fundamental, until all of the mal-investments are washed clean (i.e. the foolish mal-investors lose their shirts, or if they are smart, they get foolish taxpayers to loose theirs instead).

For example, in the case of oil, one of the big mal-investments in the 1980s was North Sea Oil, which had a breakeven of $12, which sounded great at $40.

And then the bubble burst, so all the expensive production capacity that had been bought on credit got to be “underwater” (no pun intended), which is how the English ended up stealing all of Scotland’s oil and selling it at the bottom of the market.

Of course one mustn’t forget the Law of “What-Goes-Around-Comes-Around,” which explains why Bonnie Prince George Brown (presumably for a modest consideration) sold off all of the Bank of England’s gold at the bottom of the market, proving conclusively that it’s never a good idea to get between a Scotsman and his Sporran.

Interestingly, prior to 1973 the oil producers, particularly the Shah of Iran, were complaining that the “Seven Sisters” were manipulating the price of oil down.

Looking at the chart, perhaps he was right, although it didn’t do him much good, because he got branded as a “loose-cannon-biting-the-hand-that-feeds."And so when the Iranian population started to be revolting, no one lobbied on his behalf in the places that mattered, and he got hung out to dry.

So much for the grand theory; the practical value of “BubbleOmics” is that you can figure out precisely where the fundamental really was (that’s the red line) by comparing the top of the bubble with the bottom of the slump that follows.

Perhaps that can explain the “fundamental” mystery for why FOOT is such a lousy explanatory variable for the price of oil?

According to the Seven Immutable Laws of BubbleOmics, short-lived bubbles -- like the oil-bubble in 2008, where the fundamental won’t have changed much (in the short-term demand for oil is not driven by price) -- the “fundamental” (that’s what International Valuation Standards calls “other-than-market-value which is what the price ought to be if the market was not being manipulated") is defined as the square-root of the “top” multiplied by the “bottom." That’s a pretty universal characteristic of bubbles, and most of the time it’s pretty accurate.

Do the arithmetic for the recent bubble in oil prices taking the 30-day MA, i.e. the square-root of ($127 x $46.5); that gives you the “fundamental” in early 2009 at $76.5, which is a way of calibrating the fundamental line.

That’s illustrated in this chart:

Oh my goodness! The “fundamental” worked out by BubbleOmics is slap-bang on the line of the “fundamental” worked out by Parasite Economics!

But perhaps that’s a coincidence?

Well, there is one way to check that out, because there is another point of reference, which is/was the collapse of the 1980s oil-bubble.

BubbleOmics also says that extent of the under-valuation reference the fundamental, after a “pop,” is exactly equal to the extent of the over-valuation in the preceding bubble (that’s mathematically the same as the square-root storyline).

Well, at the top of the 1980s bubble, oil was selling at 2x the “fundamental” as it’s calculated here, then went down to half the fundamental; that fits.

But okay … just one line and two points worked out by third-grade arithmetic … that’s hardly Black-Scholes!

Why that’s interesting is because you got one simple line that comes out of dividing one “clean” string of numbers by another “clean” string of numbers (by that I mean numbers which are consistently reported and not dramatically manipulated), which gives you a best fit with a constant of about 3.33 percent.

Then you got two points that came out of a completely different line of logic, based simply on multiplying two public domain numbers together, and 3.33% pops out too.

That’s three coincidences (well, actually four). This is what I posted in October last year:

It’s highly unlikely oil prices will go down much although typically the periodicity of a bust is the same as a bubble (this time about 18 months), so expect oil to head up towards $80 by April ... then the price should bubble along and quite possibly hit $90 by the end of 2010.

So here we are in the twilight of 2010, and oil prices are knocking on the door of $90, and as my niece will tell you, the acid test on a model is, can you do it in real time?

Reverse BubbleOmics

Most people think of a bubble as when prices are manipulated upwards above the fundamental that leads to mal-investments, etc., so you get a slump afterwards which typically lasts as long as the previous bubble.

But you can have reverse bubbles; those start off when prices are manipulated down, which leads to sub-optimal investment in new capacity, maintenance and development of alternatives. One example of that is rent control, which pushes prices down, but that creates bubbles downstream in the “non-controlled” parts of real-estate markets -- which is one of the reasons there was a bubble in Dubai property.

It looks like that happened prior to 1973 for oil. When Iran and Iraq stopped pumping on account of deciding to spend 10 years trying to blow each other up, there was no spare capacity because there had not been enough investment -- because there wasn’t the money in oil to pay for it, or a reason to invest in energy conservation.

Thus the bubble that followed was arguably “caused” by the previous manipulation of prices (down) by the Seven Sisters prior to 1973. And perhaps all that stuff about “Arab solidarity” and “throwing Israel into the sea” was just hot air to justify the price increases? Certainly, in the event, what happened is that after they got the price they liked, any traces of solidarity disappeared into the mirage.

Perhaps there was also a reverse-bubble created starting in 1997 when, according to the theory, prices should have been heading back towards the fundamental (Point “D”).

Then there was the Asian Crisis, which can’t be easily explained by this analysis; perhaps the Saudis persuaded themselves or were persuaded to “be fair” so as to promote world economic growth, then things recovered and prices started to go up towards point “C." And then there was 9/11.

Perhaps there was a quiet “quid-pro-quo,” and the Saudis promised to set aside their old ideas of being economic terrorists and commit to becoming the fairy godmother of last resort, with regard to oil prices? Sort of like an “Oops, sorry!” moment?

And so they pumped for all they were worth, which was great … short-term, and except that it caused a “reverse bubble."

And then they could pump no more. And then the result of so many years of under-investment in oil or in substitutes for oil produced a “reverse-pop,” which might have been one of the reasons for the bubble in 2008?

The numbers sort of pan out; depending on where you draw the line, by that logic the fallout from 9/11 might have caused a reverse bubble and brought prices down to 1/1.75 of the fundamental, which is about how much prices got inflated in the 2008 bubble -- and the timings are in synch too!

So how much oil has Saudi really got?

There is another point here, which is the question of how much oil Saudi actually has that it can pump out so as to “be a responsible world citizen." They say they have 246 billion barrels, which is enough to supply the whole world for 10 whole years.

Er ... and after that? Er … and maybe they are lying?

Perhaps the Saudis, when (if) they were negotiating about the possibility of getting carpet-bombed after 9/11, were tempted to say, "Don’t worry, we have easily enough oil to keep the price down -- trust us!”

Except there are some people (pretty smart ones at that), who say that’s not true; although, until WikiLeaks manages to come up with any evidence of that, no one will know -- until, perhaps, Saudi starts to seriously run out of cheap and easy to extract oil.

There is a clue there though. When Prince Turki was justifying the Saudi “target” of $70 to $80 he didn’t say, “That’s how much money we think we can suck out of the world without it suffering too much"; he said, “That’s what it will cost us to invest properly in the new capacity to be able to pump."

But it costs less that $6 per barrel to pump the “easy to extract” oil out of Saudi, so what are they worried about?

What Happens if Saudi Runs Out of Oil?

If the Saudis are being economical with the truth about how much oil they have, that could be a game changer.

Up to now, the supply of oil to the world has been dictated by how much the oil producers want to pump, not particularly what they can pump if they set their minds to it; plus the buyers have done their bit to persuade, cajole, and force them to pump “enough” to keep the price “right,” at least as determined by their own interests.

But the recent admission by IEA that they had been fudging their books for the past 10 years was as significant an event in the oil world as, for the rest of us, the announcement that the Roman Catholic Church has approved the use of condoms. What those two announcements have very much in common is that they are an admission of past delusions.

But if the proponents of Peak Oil are right and the spread of HIV is slowed thanks to increased condom utilization (affects GDP), then quite soon the way that the oil market worked over the past 40 years would become irrelevant. Because in that case the “correct” way to price oil would not be determined by consideration of how much blood to safely suck (Parasite Economics); it would be at the replacement cost.

No one knows what that is, and if they do they are not telling. Sure, at $75 it makes sense to start to re-open the shale fields, and to keep going after deep-water oil, but there is no telling how much those sources will cost to bring in, once 30% or 50% of the world’s needs are from that source. The easy stuff is cheap; then costs start to go up exponentially.

Interestingly, the price of gold, which traditionally is a good marker for the price of oil (and vice versa), at $1,300, is signalling $138 oil.

Predictions:

  1. The price of oil will never go lower than $75.
  2. If Saudi is able to deliver on its promise to keep oil prices “fair," then while that lasts oil prices will go up broadly in line with the growth of world GDP in nominal dollar prices, if, as is commonly believed, world oil production has peaked and it will “flatline” for the next five to 10 years.
  3. If (or as soon as) Saudi is unable to deliver on that promise (or that becomes public knowledge), or if the flatline starts to dip dramatically, then oil prices will start heading up towards the long-term replacement cost; "long term" as in the cost to get out the really expensive oil, which if gold is any guide is $138 in current (2010) prices.
  4. If someone decides to start lobbing ordinance at Iran; and they decide to get “itsy” about that and decide to deploy their sunburns, and they work, then there could be a period when the supply of oil to the world goes down at least 25%.

Based on the 1980s bubble, when there was a 25% drop in production, that suggests a 25% reduction in consumption would lead to a 2x bubble in price (over the fundamental), plus a 33% increase in “fundamental” due to the drop in production.

Combined with perhaps a 10% drop in “real” world GDP (which would mitigate the rise in price), oil prices could go up to $90 x 2 x 1.33 x 0.9 = $215 in current (2010) prices. There would also be inflation averaging 10% over the next 10 years (caused by oil mispricing), which would bring oil prices up to $550 by 2020.

How long can the self-delusion last?

If Americans are starting to wonder just how delusional their government was over the past 10 years (and not just in relation to oil prices and the disruptions that the tax to the blood-suckers has cost them), they can comfort themselves that the British government, thanks in a large part to the efforts of a nasty little man called Tony Blair, has been even more delusional.

You can look the whole story up on Wikipedia, but I remember that in 1995 Dr. Colin Campbell made a presentation to the British Parliament explaining to them in words of one syllable that oil would peak worldwide in 2007 (something that the IEA has conceded four years late (they say it was 2006)), and that there would be a dramatic increase in prices (then they were about $15).

No one listened; they just kept pumping out Scotland’s oil and selling it at a ridiculously low price, until it ran out. Short term political gain trumps long-term strategy every time, in democratic systems weighted towards lofty sound-bites, cheatable expense-account living and index-linked pensions for the “in-crowd," and avoidance of pain today.

Part of the problem is the delusion that the problem will go away. There is no evidence that it will and there is a huge amount of evidence that it won’t.

There are plenty of things that governments with any interest in the long-term prospects of the people they represent, and their children, can do. The most obvious of which would be to guarantee the developers of marginal supplies and marginal technology to increase efficiency and//or to find substitutes, a minimum price-equivalent equal to the “fundamental” price, as is defined by:

“FOOT” = “TOAD” multiplied by “3.33%”” divided by “OIK”

How crazy would that be?

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