Sunday, December 21, 2008 7 comments ++[ CLICK TO COMMENT ]++

One of the big stories of 2009: Crude Oil

Crude oil is going to be a big story in 2009--for both investors as well as for the economy. I'm staying as far away from oil as possible but it is an interesting situation for investors.

Oil & The Economy

One of the reasons the economy hasn't done as badly as some of the pessimistic forecasts from early in the year was because of the massive decline in crude oil. Calculated Risk estimates that the decline in oil provides around $20 billion per month in extra disposal income (compared to prior spending.) This is equivalent to almost 1/4 of the big stimulus package that is being proposed. If you add in the decline in other commodities, you can see how big of a stimulus this has provided in this recession.

The decline in oil (and other commodities) is, of course, bad for the oil industry (and related industries.) Roughly speaking, decline in oil is good for USA because it is a big user; but it is bad for the oil producers, whose economies are getting clobbered. One just needs to look at Russia and Brazil to see how the free market benefits some and hurts others. As for Canada, decline in oil is neutral in my opinion. Canada is a big producer of oil but almost half (or more) of the economy is manufacturing and services that are big users of oil. So it is a wash of sorts.

Oil & Investors

For investors, it has been a wild ride but the really volatile period could still be in front of them. So far oil has trended with it continuously going up for a while and then continuously declining of late. If I had to guess, I would say that oil will enter a volatile period where it goes up and down 20% every few months (this is similar to my view of the broad stock market as well.) Like most nasty bear markets, it is likely that both bears and bulls will either lose big or gain big (if they can time things properly.) Some investors are thinking of going long now and it's an interesting proposition.

From a contrarian point of view, if you are bullish, the analyst estimates are not in your favour. Analysts still seem to be too bullish as you can tell by the following chart from Bespoke Investment Group:



Analysts seem to think that oil will rebound to $60 by next year and hit $100 by 2011. The ideal contrarian position would be when analysts are bearish, as nearly all of them were 5 years ago, but it's too late for that. Oil, like most commodities, is very volatile and there is nothing to say it won't hit $60 but I find it unlikely. That's around a 100% gain from current levels and without a big macro bet, such as the China bet, it's hard to see anyone pushing up prices to that level.

If we leave the analysts, who always lag trends, and look at the market itself, we see the following futures curve, courtesy barchart.com:



I only plotted a few months but you can get more data from barchart.com. Do keep in mind that a normal commodity market should be in contango (i.e. future price should be higher than current price to account for opportunity costs, storage costs, etc.) Right now, the futures prices are quite bullish, with a price in the $50's by next year, and $70 by 2013. Having said that, I don't think one should rely on the futures market very much.

There are a lot of people, including central bankers and other prominent individuals, who look at futures markets as some sort of predictor of the future. I am not in that camp. As far as I'm concerned, futures are almost next to useless and generally just extrapolate current views far into the future. If anyone looked at oil futures a few years ago you would have noticed that they were wildly off. Similarly, early this year, distant futures were pricing in very high prices (although if I recall, the futures price never hit the high spot prices around $147.)


So to sum up, it's easy for oil to rise significantly in a short period of time, but the market consensus is still too bullish in my eyes.

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7 Response to One of the big stories of 2009: Crude Oil

Anonymous
December 22, 2008 at 9:37 AM

ok . you presented a case for oil with indicators pointing it is going up. but your point view which is bearish is based on??? sentiment or a feeling?

you got to give more than that. tell me the economy won't rebound, china is going to face more deep rescission than anticipated, free trade is going out of the window leading to a more protracted global rescission. Alternative energy in 2009 will become mainstream.

A contrarian have to have a case or a thesis not just to be contrarian for the sake of it.

Anonymous
December 23, 2008 at 10:50 AM

When the cost of finding new oil is $60+/barrel the price cannot stay this low without long term consequences. Either way those long oil and patient will be rewarded.

December 23, 2008 at 11:56 AM

Anon #1,

You are right in saying that I need a stronger argument to be bearish. I am only mildly bearish, rather than fully bearish.

I think sentiment and consensus expectations are important. Contrarian for the sake of contrarian is dangerous but it doesn't preclude one from stayign away or maintaining a mildly bearish view when everyone is on the same side of the trade.

December 23, 2008 at 12:15 PM

Anon #2,

Commodities, in theory, should trade close to the marginal cost of production in the long run. The problem with the $60+ cost of production figure is that, I believe it is exaggerated.

Costs had run up significantly due to the commodities bubble (e.g. high steel prices, copper prices, etc). Even capital goods, such as tractors, cranes, movers, etc, had seen huge increase in prices. Oil service companies were charging an arm & a leg for drilling, food, sanitary maintenance, etc. Labour had also run up a lot. In Alberta, the oil sands region in Canada, people working in a coffee shop were making as much an entry office worker in Toronto because oil sands was pushing up labour costs. Costs in other parts of the world, such as the Middle East and Brazil, were likely high.

I would argue all that run up in price was unsustainable. Furthermore, if one is bearish (or at least not superbullish) on commodities, it is unlikely you will see such high costs for a long time.

So, the marginal cost of production is not fixed, and will probably decline. Canadian oil sands, which is basically super-high-cost oil, had cost of production somewhere in the 30's 5 years ago. I recall reading articles saying that the oil sands playes were profitable at oil above $40 or something like that. Right now, articles seem to imply that oil sands are profitable above $70.

I would argue that oil sands will actually end up being profitable at prices less than $70 in the future, because costs will decline. So the notion of marginal cost of production needs to consider the possibility of declining costs.


I can see oil rallying by early next year. But I am not so sure about the long-term price. The key will be what happens in China.

Anonymous
December 25, 2008 at 2:36 PM

Mexico's leading oil producers just came out and said their production is down by amlost 10 % this year. I dont believe the Saudis. Oil fields are in decline and over the next 5 years prices will rally.

There is an argument between inflation and deflation in the media these days.

I say 70 % inflation and a probability of 30 % deflation.

Here is why the US will not go the japanese way. In Japan the central bank took 5 years to bring the rate from 6 % to 0 % . They began quantitaive easing only in abotu 2002 - 2003. Why? Because the govt was wary of the pensioers who formed a increasing % of the population beginning in the 1990's.

Please read Martin Wolf's article in teh Fianncial times for further details on why the US will not be Japan.

I would have liked the US govt to fire all the heads of bank and nationalise . This way the govt would control the "money pipes".

But maybe if the current deflation cpntinues they might do this.

December 25, 2008 at 5:10 PM

Anon,

I would agree with you that the supply side of the oil question looks bullish for oil. But one can never be sure since it all comes down to how exploration goes. For example, this BusinessWeek article from back in June says that Saudi Arabia is planning to produce from a giant new field by next year. I never even heard of such production increase (1mmboe is a lot) before (it is declining in other countries but the point that oil bulls always argue such large production increase is unlikely.)

You say that you don't trust Saudi Arabian numbers but one can never be sure. I don't doubt the Saudi Arabian numbers like skeptics do. It's very difficult to manipulate the oil market because it is so large. So, if Saudi Arabia is producing far less than they claim they are, prices would go up. What is perhaps more doubtful is the OPEC estimates of production cuts. Who knows how much is being cut or increased by each member?

In any case, I place more emphasis on the demand side. That's why I have been bearish on commodities, including oil, for a few years now. I was mostly wrong but my original feeling is turning out to be right. There is still some potential bearish scenarios that the commodities markets, as well as the broad stock market, is not pricing in. Namely, the market seems to be projecting oil consumpt to decline in developed countries but there is a small probability of economic crises in countries like China, India, and even the Middle East (which actually saw consumption increase.)


I don't have access to Financial Times so not sure what Martin Wolf is saying. I don't think USA and the rest of hte developed world will follow an identical path as Japan. One of hte big differences is the poor demographics in Japan, with more and more people retiring, which would generally contract the economy anyway. However, I do think the developed world, and some of the developing world as well, has a high probability of resembling Japan in certain aspects.

You are right in pointing out that Japan was very slow and didn't really do anything until the latter part of the 90's. But, irrespective of the timing, they have been in a mild deflation/disinflation environment. I should also note that Japan pursued far greater fiscal spending than anything being proposed by any country right now (except China--but some skeptics claim China is counting previously announced projects.) Japan's total debt is around 200% of GDP! Even if you go with some high estimate for the fiscal spending being announced, it is highly unlikely that USA or others will spend anything close to what Japan did (up to 200% of GDP when all debt is counted.) USA would have to spend roughly $15 trillion more to get to 200% of GDP.


I think the inflation/deflation call will be a big thing next year so I'll write a post about it (I have been thinking of various issues related to it but don't have any strong views yet.) One thing I will point out is the following:

A lot of the people who expect high inflation--the ones I call inflationists--are almost the same ones that tend to argue that market forces are more powerful than any government (I agree with the market force comment.) If one thinks that governments are only a part player in a free market, then how can one be sure that the government will somehow counterbalance the massive wealth destruction that has, is, and will occur? If you add in the fact that we have seen an unprecedented synchronized global boom, the global bust will be global as well.

Right now, I feel that the probabilities are more like: 10% chance of high inflation; 60% mild inflation/mild deflation/disinflation; 30% chance of serious deflation.

December 25, 2008 at 5:45 PM

If you are interested in some insightful views (bearish) check out Ahmad Abdallah's comments in this GaveKal thread. Ahmad is an analyst for GaveKal and, although I have no access to GaveKal and hence don't know what he writes most of the time, his call over the last year on this thread has been spot on.

The portion you might find interesting is the 2nd page of the discussion, where the future outlook is discussed, including the marginal cost of production, which he says is actually closer to $20 per barrel for most projects (this is news to me--I thought it was closer to $40, while some bulls claim it is closer to $80).

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