Oil on Wild Ride
An uncertain future is awaiting oil prices. Even experts are no longer able to predict whether the oil price would go up or not. The frustration of experts could be seen in their conflicting analyses. They estimate the price of black gold in a wide range between $30 and $200 a barrel.
After falling nearly 60% from a peak last June, the price of oil bounced back more than 20% as January turned to February. Then, it sunk 5%, closing just above $50. Oil has fallen or risen by 3% or more on 14 of 27 trading days so far, this year. By comparison, the stock market hasn’t had a move that big in more than three years.
Predicting prices is especially tricky now because the oil market has never quite looked like this. Oil price collapses of the past were triggered either by plummeting demand or an increase in supplies, and the latest one had both. Production in the US and elsewhere has been rising, while slower economic growth in China and weak economies in Europe and Japan means demand for oil isn’t growing as much as expected.
More Fluctuations
As recent trading indicates, any sign of reduced production inspires traders to buy oil, and every new sign of rising supplies sends prices lower. In a report, the US Energy Department, citing unusual uncertainty, said the price of oil could end up anywhere from $32 to $108 by December.
“There are many more laps to come on this roller coaster,” The Associated Press quoted Judith Dwarkin, chief economist at ITG Investment Research, as saying.
As oil prices bounce up and down, so will the price of gasoline, diesel and other fuels. Almost no one expects a return to the very high prices of the last four years, so drivers and shippers will continue to pay lower prices. It’s a question of how much less and for how long.
Three scenarios are bandied about.
- Oil Will Rise
Those expecting a quick and lasting price jump see mounting evidence that drillers in the US are pulling back quickly because they are no longer making money. A closely-watched survey by the oil services company Baker Hughes shows that the number of rigs actively drilling for oil fell to 1,140 last week, down 29% from a record high of 1,609 in October.
Oil companies have announced spending cuts in billions of dollars; oil service companies have announced layoffs of thousands of workers.
If companies stop drilling new wells in North Dakota and Texas, the centers of the US oil boom, overall US production could fall fast. Output from most of those wells declines far more quickly than production from more traditional wells. Analysts at Bernstein Research estimate US production declines at 30% a year without constant investment in new wells.
A quick decline in production would send prices higher by reducing global supplies. At the same time, demand could be on the rise. The US economy seems to be improving rapidly and demand for gasoline is increasing. Global demand may also rise somewhat simply because low prices tend to encourage more consumption.
If the oil bulls are right, it means prices for transportation fuels would rise and the slowdown in drilling activity in the US would perhaps be short-lived.
- Oil Will Fall
Others say oil production is still rising and demand isn’t yet catching up — a recipe for lower oil prices.
The oil bears argue that there are plenty of rigs still working and they are now focused only on the most prolific spots. Also, oil services companies are charging significantly less for equipment and expertise. This means oil companies may be able to keep oil supplies rising from already high levels despite low prices.
The Energy Department reported last week that there was a record 1.18 billion barrels of oil in storage in the US ITG’s Dwarkin estimates that in the first half of this year the world will be producing, on average, 2 million barrels per day more than it will be consuming.
Analysts at Bank of America Merrill Lynch say $32 per barrel is possible. Ed Morse, an analyst at Citi, called the recent rise in prices a “head fake” and predicts oil could plunge into the $20 range, the lowest since 2002.
The bears also don’t expect much increase in demand. Many developing nations are cutting back on fuel subsidies, which mean that consumers could be buying less fuel, not more. And demand in the US and other developed nations won’t go up much, they argue, because of environmental policies and high fuel taxes.
- Oil Will Stay the Same level
After its recent rise, some think oil may already be close to finding its level.
The International Energy Agency (IEA) said in a report that prices will stabilize in a range “higher than recent lows but substantially below the highs of the last three years.”
In the past, once production went off line it took years to bring it back. Now, the IEA said, drillers can quickly and easily tap shale deposits to bring new oil to market as soon as supplies fall or demand rises. That should help keep a lid on prices.
Tom Pugh, an analyst at Capital Economics, forecasts that Brent, the most important benchmark for global crude, will end the year around $60 per barrel, within $4 of where it closed Tuesday — and to be at $70 by the end of 2020.
That doesn’t mean, however, there won’t further be bumps along the way. “We wouldn’t be surprised to see larger price movements before the market settles down,” Pugh wrote.
$45-$60 Return
Back in May 2008, nobody — especially regulators — had a clue about what was causing crude oil prices to spike to $100-per-barrel-levels, and mostly everyone was inclined to either blame “China” or “speculators” or some combination of the two.
But Michael Masters, a portfolio manager at Masters Capital Management, had a simple proposition. In the Senate committee hearings organized to figure out exactly what was going on, Masters testified that it was his belief that a new class of investor — one he dubbed the passive “index speculator” — had bulldozed his way into the market and distorted the usual price discovery process.
Everything, Masters added, comes down to appreciating that “volume times price” is always a better investment than price alone.
“If you look at the returns in crude, where you typically had backwardation before index funds moved into commodities, that shifted to a situation where there was much more of a contango structure, which penalized those who were synthetically storing crude because the price in the future was higher than the price before, benefiting those storing actual crude,” he said.
“The point is there is all this stuff you have to deal with owning the price alone, which is really just speculation versus owning the means of production which benefits from volume increases, as well as price.”
But Masters said he is not completely against speculation.
“You need a little bit [of speculation] to grease the wheels of commerce,” he offered. “It’s just that when it’s all speculative flows it creates booms and busts and more volatility than is necessary for price formation to take place. If you put enough capital in anything, you destroy it.”
At this point in the cycle, it’s Masters’ opinion that the market has to appreciate that at $45-60 per barrel returns can still be generated and that will keep production and efficiency flowing.
“Everyone will cut the cost of what they are doing but they are going to keep doing what they’re doing and keep doing it more efficiently. If you cut the cost, the production will keep flowing,” he stressed. “You’re going to get the production, but with less economics for the E&P businesses and with less economics for your vendors. Things will get cheaper and people will simply make fewer returns.”