Charting Oil: The Statistics Behind the Hype

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Includes: OIL
by: Sean Bellamy McNulty

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

- Charles Mackay - Extraordinary Popular Delusions and the Madness of Crowds (1841)

After being witness to the riots in Vancouver this past week, this maxim is even more profound. As I watched the madness unwind, parallels between this mob and the mob that trades in the markets everyday became apparent.

Specifically:

Productive, generally rational members of society will commit unexplainably stupid acts when caught up in the euphoria of a crowd.

The individuals who are able to keep their wits about them but take contrarian positions too early face painful consequences.

Eventually, fundamentals will drive outcomes.

I used to believe there was only one phenomenon that could cause good people to do terrible acts, I now see that there are two.

The greatest difficulty with the madness of crowds is knowing when you are, and are not, joining in the groupthink that accompanies them. Admittedly, this is relatively easy to do in a riot, but this is not the case in the markets. The pundits, anti-pundits, manipulation of statistics and emotional swings that are tied to managing money make seeing the forest through the trees a challenging task at the best of times. This is especially the case with the most watched commodity on the planet, crude oil.

Crude oil is the lifeblood of our economy. It is an input into nearly every economic activity we undertake and can single handedly lower the world's GDP. Due to its great importance, there is a tremendous amount of hyperbole, making it difficult to tune out the “oil is en route to $140 per barrel” crowd and the “oil should be $60 per barrel” crowd.

This articles purpose is to cut through this noise, providing unequivocal facts by utilizing the latest available data. Let the charting begin:

World oil prices move together.

With the spread between WTI and Brent at all time highs, a regression to the mean trade is highly likely to pay off eventually. The question, as always, surrounds whether the investor can remain solvent in the meantime.

High oil prices = Lower oil consumption - (click charts to expand).

This is intuitive, but I still encounter individuals who believe that no matter what price oil goes to, there will be buyers. Observe the consumption change year over year at $45 per barrel in 2004, to $90 per barrel in 2007.

Also worth noting, World GDP continued to grow at 4% plus with oil priced around $75 per barrel.

Economic growth has a strong impact on oil consumption.

If there is a slowdown in the US, oil prices will suffer, and vice versa.

OPEC’s spare production capacity is higher now than it was in the run up of prices from 2004 to 2008.

Although OPEC aristocracy refused to increase production at the last meeting, they do have the ability to do so, and given the sheiks' penchant for living in the lap of luxury, it would be reasonable to conclude that as prices rise the profit motive will put increasing pressure on them to up production.

World liquid fuel production capacity growth is at historically low levels.

This is the realm where I see a black swan event occurring being most probable. The history of human ingenuity is a rich one, and it would be a historical first if a new technology of some sort wasn’t invented to deal with the challenges faced in the future production of crude oil.

This could take many faces, such as a breakthrough in a green technology or a breakthrough in the extraction of oil such as Shale Oil. I will not join the charlatans who claim to know what it will be, but I am confident history will be repeated.

News is a powerful catalyst.

Be nimble in your directional bets, especially around news events.

Producers hedge, money managers go long, speculation does play a valuable role.

Without the money managers on the other side of the trade, there would be no way for companies to hedge their exposure to violent fluctuations in commodity prices. Therefore, despite what your local bureaucrat is advocating, the markets do serve a purpose on “main street”.

Diversifying within commodities is offering less and less protection.

More evidence that diversifying across asset classes such as stocks, commodities and currencies is sensible.

Given that the future is a consequence of the present, I trust that this data will assist in your assessment of the oil market. As for myself, I’d speculate that it is heading lower, to the $75 - $85 range, as investors recover their senses slowly, one by one.

*All charts sourced from U.S. Energy Information Administration.

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