As Predicted, the Oil Price Reverses so What's Next?
Identifying bubbles is not (very) hard, what’s hard is predicting at what price and when they will pop. Two weeks ago I wrote an article titled “FAO Food Index Predicting a Reversal in Crude Oil Prices”. I’d say a 15% decline in Brent from $127 to $110 qualifies as a “reversal”. Outside of noticing that food prices slightly lead oil prices, the logic behind that argument was:
1: The Libya thing was a Red Herring used by the speculators to instill a bit of panic into the market; there never was a short-fall of oil compared to demand (short-term) and there still isn’t.
2: The Saudi’s might have a sulk about what they perceived as misinformed and impolite comments from various corners of the US Administration about the human rights of minorities and all that baloney. But ultimately, they know that the alternative to sucking up to America (making sure oil does not get too expensive for America’s taste), is not an option, and they know America knows that and America knows they know America knows that. Perhaps it wasn’t a coincidence that oil prices tanked soon after Osama bin Laden was in the news (hopefully for the last time), and as that subject hit the headlines, memories were jogged that 14 out of the 19 terrorists in 9/11 were Saudi’s?
3: The correct price of oil right now valued according to what the world can afford to pay (without suffering unduly), is about $90 (Brent). So at $127 oil was a 40% bubble, bubbles do have a habit of popping once they get to 40% over the “fundamental”.
Where Next?
Well, according to the theory, if oil was 40% too high, and if no one is taking the spectre of peak oil too seriously (in which case the “fundamental” value is the replacement cost (i.e. what it will cost to find and produce more oil)), then at some point in the not-too distant future the price of oil “ought” to explore $90/1.4 = $64 (Brent). Whether it does or not, will be a good test of how much the “Peak Oil” idea is gaining traction.
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29 comments
ee
What makes you think the likes of BG group will be able take home their growing profits with growing production over time when you have governments around the world that want to tax big oil ? Just look at what Obama is saying in the US about tax breaks on Big Oil and Osborne's North Sea tax hike.
M&A - at some point they will get bought out for Brazil by a US company to plug the holes in US supply.
Re Obama's comments they seem viewed as pre-election bluster (per today's FT).
I suspect Osborne will do some significant back-peddling as the truth dawns on the Treasury.
ee
No doubt there is a speculative premium in oil right now. Why would there not be? It's the most important substance on the planet, and is still extraordinarily cheap for what it (uniquely) does. In the UK petrol remains cheaper than most bottled water, which is a completely unnecessary product.
This "reversal" is purely down to on-going margin hikes at the CME, which very temporarily throw out the most leveraged longs.
http://www.zerohedge.com/article/and-todays-margin-hike
Jim Cramer sums it up (first sense I've ever heard from him ...)
http://www.cnbc.com/id/42994665
This seems to be related to Obama's recent announcement of a "war on speculators" in the oil and gas markets.
I bet the ICE is smacking its chops.
Speaking as a retired IT Director, IMHO mechanisation and automation have undoubtedly improved productivity in manufacturing - if you mean productivity per human employed. But if you consider our economy/society as a whole I don't agree that they have improved productivity at all.
What they have done is stimulate resource reallocation so that millions of people are now employed in doing tasks which are not really necessary. Our systems of administration and control have grown into over-complex and massively centralised processes.
Consider how many people are required to run our tax system - not just HMRC but the staff in businesses and even private individuals. Consider how few would be needed if we rationalised and stream lined things. And reflect how few were employed in doing equivalent activities 100 years ago.
Or health and safety.
Or communications technology - what % of telephone traffic can be described as real value adding?
The other big issue is the outsourcing of work to low wage economies. That process is definitely on a pareto curve where the steep change gradient is flattening very rapidly.
Intreresting thread. Two points:
1. Re: Technology. Before I left the Army 13 years ago I attended a NATO conference on Artificial Intelligence. IIRC, the USAF were predicting that their first squadron of unmanned fighters (NOT drones) would be formed about now. The drive to take the man out of the cockpit was intense - not only does it free up the aircraft to take the sort of G that humans cannot take, but the training costs are much cheaper since so few flights need leave the ground! I am well out of the swing and I have no idea where the programme has got to - but I have absolutely no doubt that major advances will have been made and that many of these will have civilian applications. In fact, I have a fear that us investors have only a decade or so to make our fortunes before machines with AI render the market efficient at last (dammit!).
2. Re: The Rise of the East. It is easy to see that the East is rising while the West strangles itself with regulations and well meant social engineering. But I look forward with interest to see how the BRICS will get on with each other as they all gain power and start jostling. Russia and China have an uneasy history, for a start. My guess is that the only thing that is predictable is that something unpredicted will happen. When I feel grumpy (often) I have to remind myself that I still wouldn't want my children to live elsewhere.
AA
AbAngus,
Quite right re technology being employed in warfare. This article was printed in yesterday's FT and includes reference to just some of the advances made in military tradecraft:
Other stories linked from this FT article just in the last month also make reference to the use of drones:
US kills eight in Pakistan drone attack - May-06
US drones kill 25 in Pakistan border region - Apr-22
Pakistan condemns CIA drone strike - Apr-13
Meanwhile the MoD is to consider the ethics of using unmanned craft in this Guardian article whilst this Washington Post article asks if military decisions will be made much sooner due to the ease of deploying unmanned Predator drones.
Which ever way one looks at the increased use of technology it is certainly reducing loss of life in conflicts so in general terms it is 'a good thing' that advances are adopted by the military, assuming ethics are considered in the process of their use.
There's corruption everywhere(except here we call it MP's expenses)............................and the hoards of people wanting to live in the UK we could argue arise from our generous welfare state,and free NHS. It's hardly a cheap standard of living here that's for sure!
Spot on regarding how the West is perceived. The time of the West is over, the time of the East has begun.Larger,more youthful populations, a general hunger to learn and succeed that seems to be fast disappearing in the UK. and far better taxation rates..16% Hong Kong, 20% Singapore for starters. Yet still they run budget surpluses and are rapidly building up significant reserves. Why would anyone want to work here and pay 50% plus is beyond me when they can do the same job overseas and keep more of their hard earned...
I don't buy the east is best gonig forward argument for one simple reason - corruption.
Look at the hoards of people wanting to live in the UK for example.
Have to concur with your thoughts Repo - Technological advancement has only just begun imv and the applications of current technology not fully appreciated. There are still significant advances to come, some which I fear will leave us with less liberty.
Spot on regarding how the West is perceived. The time of the West is over, the time of the East has begun.Larger,more youthful populations, a general hunger to learn and succeed that seems to be fast disappearing in the UK. and far better taxation rates..16% Hong Kong, 20% Singapore for starters. Yet still they run budget surpluses and are rapidly building up significant reserves. Why would anyone want to work here and pay 50% plus is beyond me when they can do the same job overseas and keep more of their hard earned...
In "The Singularity is Near", Ray Kurzweil argues that we're about to hit the inflection point of an exponential technology growth curve - http://www.singularity.com
I don't think anyone knows and he's probably mad but it's an interesting and rather mind-bending book that's worth a look.
http://en.wikipedia.org/wiki/Ray_kurzweil
http://en.wikipedia.org/wiki/Technological_singularity
Don't confuse the huge increase in the use of certain types of technology with their contribution to economic growth. Speaking as someone who left school before PCs were widely available, I have no trouble at all in saying that the economic gains from technological change over the last 40 years are much greater (in percentage terms at least) than the gains that can be expected over the next 40.
Of course there is the possibility, per Dodge's comment of a new killer app that makes a step change in some aspect of economic life - but I really can't see any significant inefficiencies in communication or computing capability that remain susceptible to material improvement via better technology. Tiny incremental improvements, though, are a certainty - they just won't contribute much in relative terms to the greater good.
ee
Of course there is the possibility, per Dodge's comment of a new killer app that makes a step change in some aspect of economic life
Isn't that Twitter - people spend all their time twitting and economic output goes down and down!
We could have lots of fun speculating as to what the killer app might be. Perhaps some bright spark will figure out how to make computers genuinely intelligent for example. All of us know the frustrations of dealing with the currently available machines. I have no doubt that it will happen as some point, the big question is whether it will be in 10 years or 100 years. Even if there is no more than an incremental improvement in computing, I think its highly unlikely that there won't be any economically significant breakthroughs elsewhere - energy production or biotechnology perhaps.
Even if Ray Kurzweil is a bit potty, I agree with him that the rate of progress is increasing all the time. Scientists can now share ideas and analyse data like never before.
For me this is one of the few bright spots in an otherwise extremely worrying economic picture.
Anyone predicting the end of growth because there are diminishing returns from computing is badly mistaken in my view. The pace of technological change has been astounding over the last 10-15 years and it is getting faster, much faster.
You'd have to be a bit of a dinosaur to to think that nothing will come along to replace it, imv.
The West will increasingly be seen as it as though. Ageing and over taxed and there will be greatly reduced incentives for our more talented youngsters to hang around to pay people to wipe our arses when we really are well past our sell by dates.
repo
Well now, following on from the attack on Silver, seems that "the powers that be" have decided to see what effect they can have on speculative excesses(?) in Crude:
BULLETIN: CME hikes margin requirements for crude-oil trade, effective Tuesday
http://marketwatch.com/bulletins/redirect/go?g=67ED8117C56D4D328EE542D0F6CAE59A&d=bnbt
Andrew
Did you predict Brent was going up almost $7 today?
Perhaps this comment is no longer valid...
I’d say a 15% decline in Brent from $127 to $110 qualifies as a “reversal
Some reversal that was.
FWIW Stock Markets & Commodities are going higher this year imo.
OK so it wasn't a reversal.- I'm not calling a top.
My point is simply that oil is overpriced based on it's intrinsic economic value (to the buyers) - if the price does not reverse then (a) economic growth will stall (b) prices of things will go up (the purists say that's not inflation - inflation is simply about printing money ... so I won't call that inflation, although I don't know what it's called).
This argument is one that has been repeatedly advanced for the last 10-12 years, at all price levels from $20 upwards!
The counter-argument is that unless oil becomes seriously "over-priced" and maintains that "over-priced" status for multi-year periods, then there will be insufficient stimulus for investment in the new technologies that will be necessary to replace oil usage once the oil really does "begin to run out". Of course oil will never "run out", but if there is to be a smooth transitition to new technologies there is a serious need right now for R&D of alternatives. One has only to look at the modest rate of progress achieved with electric vehicles (and their even more modest market impact in the real world) to recognise that we are looking at multi-decade timelines....and, in that context, "high" oil prices play an absolutely essential role (because nobody would fund R&D into alternatives whilst there appeared to be a reasonable chance of oil prices declining significantly).
The influence of oil prices on economic growth is much exaggerated (mainly advanced by economists who are effectively data-mining over relatively short periods). IMO the western world is reaching the end of an economic life-cycle that will naturally lead to low/no growth in their economies, as a result of two completely independent influences coming to a natural end at a similar time...one being the post-war demographics of the baby boom and the other being the development of computing power - both of which have been MASSIVE drivers of economic growth in recent decades in the west.
ee
as a result of two completely independent influences coming to a natural end at a similar time...one being the post-war demographics of the baby boom and the other being the development of computing power
Computing power is still improving all the time. Why is that driver on the wane?
Diminishing economic gains from the further improvements. The big (absolutely enormous) gains have already been made.
Perhaps, but before productivity was improved with computers I think few would have anticipated the improvement. Its hard to say how technology will improve things in the future, but it might still provide an unexpected boost.
Ooh, that's very debatable I'd argue. There's just no way you can make that statement with any degree of assurance!
As a pure off the top of my head example - look at the huge increase in use of smartphones (i.e. on the move huge computing power) over the past two years - I can see this trend getting ever more rapid as well.
Darn you won't go away!!
Actually I pretty-much agree with what you are saying,,
The "over-priced" scenario is an acknowledgement of "Peak Oil" which means that investment will go into developing more oil.
There is a schizophrenia at work right now - the last time the Saudis (with the help of Iran) pushed up oil prices, that led to the development of North Sea Oil, and thanks to the decision of the UK government to trade selling their Crown Jewels for a low price - unrealistically cheap oil - until it ran out.
So the Saudis are in a three-way mess (a) they know they lied about their reserves (b) they hate it but they want to keep USA happy (c) they have "home-grown" terrorists.
What is stopping a sensible debate about the right price for oil - which is stopping development of exploration and conservation (energy efficiency), is the uncertainty of oil prices.
...mmm...looks like we are getting towards some agreement then....
But before we get too far ahead of ourselves..... ;-)
I don't agree that the uncertainty is stopping sensible debate. But I do recognise that it is stopping a definitive plan of action. The problem at present is that the uncertainty gives succour to both sides of the debate.....and actually what is wanted for a definitive plan is a general, widely accepted recognition that prices are going to move in one direction or the other.
Since I've been actively watching oil price debates (12 years now), we have moved from a situation where probably less than 10% of participants expected a material price rise (from the then $10-15 range) to one where perhaps 55-60% expect a material price rise (from the $95-115 range). This slow change of expectations is largely what has driven the price higher. The question is: how will expectations change from here?
As ever it is difficult to call. But the elephant in the room here is undoubtedly Saudi Arabia. If Matt Simmons was right (in TITD in 2005) to warn that the Saudis were soon to see a production fall - thanks mainly to Ghawar coming off plateau production (the highly productive north end of Ghawar started production some 60 years ago)....something which, lets face it, is certain to happen at some point - then oil prices will only move in one direction .....which is higher...much higher. And quickly.
In an ideal world, the oil consuming nations would already by well down the track of energy conservation, alternative fuels etc by the time that happens.....and one crucial function of a generally higher oil price over recent years should be to stimulate such (rather unpopular and unpalatable) moves. But, whilst uncertainty remains, the consuming nations are reluctant to bite the bullet - and the volatility of oil prices (and the constant finger-pointing at "speculators) doesn't help them do that!!
It is a GREAT error.....possibly the greatest error that governments can ever make....to assume that things will continue pretty much "as normal" in relation to oil supply. Ceteris paribus should have no place in the planning assumptions for energy policy - the planning should be for something like 90% of the worst case scenario for oil supply.......because, if it isn't, then there is a severe risk of some crippling price shocks that will shake the global economy to its core.
People complain about oil prices of $110-120 a barrel. They complained 10 years ago in much the same way when oil prices were $25 a barrel. Prices "must" go down, they said. They were wrong - and IMO (partly due to the Saudi shoe waiting to fall) they will be seen to be wrong again.
What would they say about $500 per barrel? What would that do for world trade, or for the US economy?
I hope we never have to find out - because I hope we can get a consensus that prices are certain to rise and that governments around the world will start aggressively influencing the way their populations organise their lives so that they will be able to cope with continually-rising energy prices. These things take time...decades...to come into practical effect - and there may no longer be decades left for governments to act.
Cross your fingers!
cheers
ee
Uh-huh.
I noticed it was replacement cost - that was in the section I quoted.
I also know that "relacement cost" isn't inflation-adjusted into the indefinite future but is merely a current cost figure (as opposed to historic cost). If you are going to talk about future replacement costs ("long-run replacement costs" in your earlier article) then you need to define your timeframe and allow for cost inflation - which you weren't doing....hence my comments.
Silly me for thinking that you didn't understand the terms you were using then :-)
Do be sure to keep us informed about how your trade works out (in inflation-adjusted terms, of course)
Best
Whats my view? Possibly the most simplistic load of old cobblers I have read for some years.
Certainly there was speculative excess to be unwound, as can be seen by last Thursday's surprise fall - which surprised some of the biggest and best - but I suspect that in fact the panic sales went too far too fast.
What an absurd argument. "Peak oil" may or may not be here already - it doesn't really matter for oil prices. What DOES matter though is that extraction costs, finding costs and taxes are all on a rising trend - and that means that the long-run replacement cost is probably significantly above present prices. In the absence of more substantial finds along the lines of Kashagan and the Brazilian fields, oil prices will continue generally to rise.
You won't be able to buy oil in 2020 for the historic cost of producing it in 2010.
ee
Why thank you!!
The last time I got a comment like that was when I wrote in April 2009 that the S&P would go up to 1,200 before reversing, so I'm feeling much more confident about my conclusions now that I have your comment in the bag.
I apologize for being "simplistic", the reason I do that is so that simple-minded people can read my articles and not get the wrong end of the stick.
The argument of mine that you call "absurd" is not , you reference (today's) extraction cost, if you re-read the article carefully, you will see that I am talking about REPLACEMENT cost, as in how much money will it cost per barrel, to explore for new oil, then bring it to the market - as in the 50% or so of current production that according to the IEA needs to be found, and brought to the surface, in the next ten years or so.
Troughs and Peaks are part of any commodity cycle, therefore calling tops and bottoms is fairly easy once spikes or severe retraces start to occur.
Its far more useful if you can say when the bottom will be and what price, and when the next spike will be and what price - about 6 months ahead of them happening.
I tell you what, I will make a prediction - Oil will be back up and over 120 US$ a barrel
Pretty sure that useless call will be "as predicted" by me at some time in the future.
I totally agree with your comment about "picking a number in the future".
But you misunderstand what I'm talking about.
1: As far as I'm concerned it's almost impossible to predict the top of a bubble - every time I tried to do that I failed.
2: My point is that if you can figure out the "fundamental" then once you know the top you can predict with a reasonably good level of certainty:
a: At what price the bottom after the "pop" will be reached.
b: When the price will get back to the "fundamental".
I think that's "useful" - for example if you had read my article written in January 2009 which said the S&P 500 would bottom at 675 and that would be the time to jump in, and you had jumped in then, and after that you might have read my article in April 2009 which said the index would meander up to 1,200 - you might have held on until then, and if you had read my article in May 2009 that said "once it hits 1,200, it will reverse by 15% to 20% (in fact it was 16%), and you had sold when it hit 1,200.....
I can go on...I think those calls were "useful".
3: My other point which has been made in previous articles is that (according to me) the "fundamental price of oil" is what the world can pay, without suffering too much (Parasite Economics), but there is a possibility, that soon it will start to get valued according to its replacement cost (something else completely).
My main point was that if oil does not go down to $64 some time in the next five (5) months (assuming it doesn't bubble up again), then something "fundamental" has happened.
There are signs that oil producers are starting to do a cost benefit analysis comparing the value of money in their hand now, compared to MUCH more money for what they have left...later.