In my last post I discussed why oil service companies could make
for a great short play. But there’s a
huge caveat to that recommendation – oil prices need to continue their decline to make it
work. In this post, I’m going to try to
make a bearish case for oil, supported by current charts and
trends. To give credit where it is due, I lifted most of this data from internet sources which are credited on the charts.
The price of oil, like all commodities, is determined by
supply and demand. For most of the
noughties (the decade between 2000-2010), both of these factors were conspiring
to drive oil prices higher. On the
supply side, declining oil production in North America along with flattening production
at large oil fields in the Middle East were leading to concerns
about peak oil. Furthermore, the war in
Iraq, along with the broader war on terrorism and instability in other oil
exporting countries added a geopolitical risk premium to the price of oil. At the same time, the US was enjoying a
credit fueled boom as the country rebounded from the recession following the
dot-com bubble, and fast growing emerging markets such as China and India seemed
to have an insatiable demand for resources.
The rapidly rising price of crude seemed to do little to quench the resulting global appetite for oil. These conditions have changed for the worse.
US oil supply rising
With the adoption of horizontal drilling and multistage
fracturing technology, US oil supply increased dramatically over the past 5
years. Although we are still well below
the peak levels seen in the early 70s in absolute terms, it’s the rate US oil
supply growth that has been nothing short of incredible. What’s more significant is that the supply
response to the high oil prices of the noughties has simply dwarfed that seen
in the 80s after the 70’s oil crises.
This rising production trend looks set to continue, at least in the near
term, as new production is being brought online.
Global oil production
rising
In the high oil price years between 2005-2008, global oil
supply was in a downward trend, giving some credence to those who espoused peak
oil theory. This trend has now reversed
with new supplies coming not only from the US, but also from Canada, Brazil,
Russia, and of course OPEC.
US oil demand falling
US oil consumption, on the other hand, has been
falling. The weak recovery in the US has
not been enough to stimulate enough new oil demand to offset increasing energy
efficiency. The net result is lower
demand in the US.
Global oil demand also
falling
The picture for global demand looks just as bad. While there has been continued growth in
emerging markets, that has not been enough to offset demand destruction in the
US and Europe. Furthermore, with growth in
China and India is showing signs of cooling, it is unlikely that this trend
will reverse itself in the near future.
Price elasticity
works both ways
Historically, oil prices have been relatively
inelastic. The global demand growth of
the last decade could not be met by new supply, leading to upward price swings. Well it now appears that supply has finally
caught up while demand has cooled off, so we should expect to see price swings
to the downside.
Record oil prices in
2008 were a bubble, reflated by loose monetary policy around the world
In retrospect, the massive oil price spike
from 2005-2008 was an obvious bubble.
What’s incredible is that in spite of the weak supply/demand
fundamentals described in this post, the oil bubble has actually reflated to levels
not far from the 2008 peak. I’m sure my
readers (if I have any) will note that this is likely due to the large scale
economic stimulus packages and extremely loose monetary policies pursued after
the great recession of the last decade, and I won’t argue that point. But it doesn’t change my view that oil
prices are unsustainably high today.
With supply rising and demand falling, we should expect oil prices to
fall to the cost of marginal supply. Oil
sands project economics become challenged at prices below $70-80 so if I were
to take a guess I’d expect prices to fall to the low end of that range, or 20%
below current levels of around $90.
Prices in the low $70s do not seem unreasonable to me, and even if they
were realized the long term trend of higher prices that began in the early 2000s
would remain intact.
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