The blog has been quiet as I have been busy drilling oil wells, while working on a law degree. It has not only been that I have not had time to write, but not enough time to read which has led to a case of writers block.
My return to writing will be on one of my favourite topics…forecasting (aka guessing) on the price of oil. I admit that one should always take my opinion with a grain of salt, as I am a geologist and I work in the oil patch. But I am also an investor and economist. The first labels may outweigh the second two but not by a wide margin.
Supply vs. Demand
After a few years of an imbalance on supply vs. demand, the forecast is that supply vs. demand has come into balance.
One factor that is contributing to this the productivity per rig in US shale basins has declined.
This is likely due to the best areas drilled first. The plays have been high-graded. If this is true as more rigs are deployed due to the higher prices the amount of oil that can be added per rig will be less than in the past few years.
US commercial inventories have been declining. John Kemp (@JKempEnergy) at Reuters published the below chart showing that inventories in the USA are now within the 5 year average.
While Confluence Investment Management included commercial inventories in their version.
Oil inventories are also declining against the seasonal trend.
Both show that although oil inventories have been elevated in past years they have begun to make a substantial decline. US Commercial Oil Inventories are down to levels seen in 2015.
OECD inventories have also declined.
Saudi Arabian peaked in the summer and have been declining since 2015 and continue their decline. The below chart is of closing stocks. The Joint Organization Database Initiative describes closing stocks as:
Represents the primary stock level at the end of the month within national territories.
This includes stocks held by importers, refiners, stock holding organisations and governments.
Any way you look at it, inventories are declining in producing and developed nation reserves. Some forecasts even have oil in a deficit in Q1/2018.
One common theme of all markets is bulls become bears at the bottom and bears become bulls at the top. The following headline is from the summer of 2017.
Another common theme of market inflection points is that funds are forced to liquidate. Even God cannot remain a bull in a bear market.
One final sentiment indicator found around market inflection points is hubris. The main cost in the airline industry is fuel. Nothing dictates profits more than the cost of fuel. The below quote is not the type of thing an airline CEO says at the top in oil prices, the bottom in airline stocks.
One reason for the gap between supply and demand closing has been Asian demand.
Both India and China have increased imports of oil. A skeptic may say that China is stockpiling oil and that may be true. But they are not going to sell it back into the market. I believe China is stockpiling oil to avoid what happened to Japan in the 1940s. China wants the South China Sea properties and they do not want to be cut off from oil should the US decide that China has gone too far.
India is about to hit the exponential portion of the S-curve of commodity usage. If India has the same influence on oil prices as China did during the mid 2000’s then $100/bbl is closer in the future than one might imagine.
For the last few years there has been no geopolitical risk in the price of oil. The narrative has been that the US shale producers are the new swing producer and that unlimited amounts of oil can be brought on the market in a very short period of time. However, as the chart above shows the US shale plays have been high-graded and as that narrative changes a geopolitical risk premium will creep back into the price of oil. There are at least 5 major geopolitical stories that should affect the price of oil.
- Kurdish Indepedence
- The Saudi purge
- Increasing Houthi missile technology
- Decertifying the Iran deal
- The return of the Niger Delta Avengers
During the last boom cycle people speculated there was about a $10/bbl premium terror/risk premium in the price of oil. Should the premium be that high? Maybe not, but $5/bbl puts oil near the $60/bbl area.
The global GDP and the Purchasing Managers Indexes are near the highest since oil was $100/barrel.
Synchronized growth does tend to happen at the end of cycles and energy stocks perform best at the end of expansions and this expansion is one of the longest on record.
Phil Verleger, one of the best oil economists there is around wrote the following in 2011;
“Expect crude oil prices to touch $250 per barrel before the decade ends. This “projection” is derived from data on oil price behavior over the last five years, not an economic forecast. As can be observed from the cover graph, the range observed for crude prices has skyrocketed over the last few years. Ten years ago, the price fluctuated between $17 and $34 per barrel. Three years ago, it ranged between $31 and $146. In some year before 2020, it will fluctuate between $55 and $250 if trends continue….
Price volatility has increased over the last two decades because policy has not been coordinated, investors are not forward thinking, and producers are reactive rather than proactive. The likely continuation of these policies and practices promises to take prices to or above $250 per barrel by 2020. It could also take prices as low as $10.”
Mr. Verleger believed back in the early 2000’s there would be 4 boom-bust cycles in oil prices before technology reduces oil demand substantially.
Boom- Bust cycles
As you can see in the above chart, CAPEX cycles with oil prices. CAPEX has been cut drastically over the past few years.
Break evens for shale had been declining into 2016, but 2017 is a different story as the best areas have been drilled.
This means less wells will be drilled at prices above $50/bbl than there would have been last year.
Both West Texas and Brent have gone from steep contango to backwardations over the past year.
Backwardation removes any benefits to storing oil and selling it forward. Holbrook Working, who did all the original economic analysis on storable commodities explained that backwardation means the commodity is being summoned to the market from storage and indicates strong current demand.
Stocks are supposed to lead the commodity. Energy stocks have performed very poorly for the past few years.
ExxonMobil is attempting to break out.
Exploration Stocks are breaking out
Canadian Energy Stocks are breaking out.
The drillers are trying breaking out.
All while oil is breaking out on the chart.
While attempting to enter the old trading channel.
Indicators and Models
The Confluence Investment Management oil price model has a fair value of approximately $60/bbl.
The CME released a report on Soy Oil and how it has lead the price of Crude Oil for the past few years. I wrote about this report (here and here). Soy Oil bottomed back in early June and rallied to new highs in September before declining into October and rallying again into November.
Crude Oil bottomed in late June and peaked in early September. However, the decline was much shallower than Soy Oil. They both peaked in late October, but geopolitical events caused a further rally. Should the relationship hold, Soy will rally higher or oil will retrace.
Comparative inventories have declined and are suggesting prices in the high $50’s/bbl. As comparative inventories continue to decline it should support prices.
The Saudi stock market also bottomed back in October and has rallied to highest level since 2015. In a previous post (here and here) I wrote about how the Saudi market has been leading the price of oil for the past few years.
Finally, commodities are just cheap vs. stocks and oil is the most traded and used commodity.
I have only presented the bullish case. If you want the bearish case read there is lots of material. Almost all fundamental analysts believe oil cannot go much beyond $55/bbl.
Fundamental analysis is backward looking and subject to the vagaries of accurate government data. So what does technical analysis say?
The daily chart has a cup and handle pattern that has broken out and targets $62/bbl.
While the weekly chart has just broken out from a long inverse head and shoulders pattern targeting $74/bbl.
Oil is overbought so there is a good chance it needs to consolidate and decline and seasonally oil tends to decline into December.
But I believe oil hits $62/bbl before the end of 2017 and eventually $80 in 2018. This could be the catalyst that causes the widely expected 2018 recession.