You gotta love how the reporting follows the tape. While oil prices were shooting up, the Goldman forecast and supporting views were getting the prime real estate in news coverage. Now with a reversion, the contrary and cautionary views are getting airtime.
From Bloomberg:
Crude oil fell more than $2 a barrel on signs that a 15 percent increase in prices this month isn’t justified by stockpiles and demand.
Consumption averaged 20.3 million barrels a day in the past four weeks, down 1.3 percent from a year earlier, the Energy Department said yesterday. Prices climbed above $135 a barrel today as OPEC ministers said they could do nothing to prevent higher prices because they are pumping at capacity.
“The fundamentals justify a price between $80 and $100,” said Sarah Emerson, managing director of Energy Security Analysis Inc., a consulting firm in Wakefield, Massachusetts. “The run-up in prices has more to do with institutional investors coming into the market. There’s nothing to discourage them from doing so because the returns have been so high.”
Crude oil for July delivery fell $2.36, or 1.8 percent, to settle at $130.81 a barrel at 2:46 p.m. on the New York Mercantile Exchange after reaching a record $135.09. It was the biggest one-day drop in three weeks. Prices have more than doubled over the past year.
“Even a bull market has to consolidate at some point and it looks like that’s what’s happening today,” said Addison Armstrong, director of market research at TFS Energy LLC in Stamford, Connecticut.
Brent crude oil for July settlement declined $2.19, or 1.7 percent, to settle at $130.51 a barrel on London’s ICE Futures Europe exchange. The contract touched a record $135.14 today.
`You have to be bullish until we see a much bigger pullback than is occurring today, and when that happens we will be looking for a correction, nothing more,” said Eric Wittenauer, an energy analyst at Wachovia Securities in St. Louis.
Investors looking for higher returns moved to commodity markets over the past year because they outperformed stocks. The Standard & Poor’s 500 Index declined 8.6 percent from a year ago to 1,393.59. The Dow Jones Industrial Average dropped 6.7 percent to 12,630.83 during the same period.
“The recent surge is a function of short covering in the market,” Wittenauer said. “We are giving back some of this gain, but it’s too early to call a top to the market.”
Traders who are “short” are betting on a decline. They need to purchase contracts to close out their short positions.
“We are not in charge anymore,” Shokri Ghanem, Libya’s top oil official, told Bloomberg Television today.
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If you look at the price chart for oil in the last few days it does look a little like a blowoff that needs to consolidate. On a purely technical basis oil could retreat to $100 and still leave its uptrend in place. No market goes straight up forever but as one who is sympathetic to the peak oil argument I would expect oil prices to continue rising longterm with corrections along the way.
In this vein I would go with the comments of Addison and Wittnauer as quoted in this article. I don’t know how anyone knows where a commodity “should” trade, because, unlike a stock or bond, a commodity has no associated set of cash flows that can be evaluated. We can talk about the price of avaialble substitutes, a line of reasoning that would justify prices that are much higher. We can also talk about elasticities, which might militate for lower prices if more supply hit the markets. I really don’t know how much more one can say on this topic.
Regarding the issue of inventory: oil inventory is certainly not loose, even if the absolute inventory numbers look large. Financial analysts conventionally measure inventories in terms of the number of days’ supply. When talking about oil inventories we need to divide the number by daily refinery runs. In Wednesday’s edition of “This Week in Petroleum,” the Department of Energy stated that US crude oil inventories stood at 320.4 million barrels while daily refinery inputs were 15.08 million barrels, so we had 21.2 days’ supply on hand. Workable if all things go well but not much of a cushion against disruption, as we saw in the hurricane season of 2005.
Never believe Bloomberg’s reasons for markets doing one thing or another. They just call up a bear or bull (depending on the day’s move) to come up with something to justify the move. $135 is roughly the “correct” price for June, and the price ought to stabilize around here for a couple of months, but I wouldn’t be surprised to see a fall to $120ish before the Chinese start buying.
jonathan, I don’t think this move was a blow-off. I think it was a spike due to a series of crises at a time when inventories are a bit tight: the strikes in the UK and Nigeria, which took a lot of oil out of May supply, the earthquake in China, and China’s psycho buying patterns, which are related to their price controls. If it wasn’t for the earthquake and China’s psycho buying patterns, I think we’d see a substantial correction at this point (roughly $15), but if we do get that dip, China will start some overdue buying, and that’s a very fun ride to catch.
And commodity prices (excluding the precious metals) tend to be very rational. I can tell you, for example, that a 300k barrels per day difference in oil supply is worth $6-$7 at this time, all other things being equal. And it takes about a 15% price rise to knock out about 1% of demand at this time. You do see some moves based on emotion, but they’re also pretty predictable and tend to correct fairly quickly in a big market like oil where people actually need the commodity.
Moe Gamble
Moe, I didn’t mean to forecast that oil is dropping to $100 — or going to $200 — at any particular time. Nor do I believe media explanations of daily price moves any more than you do. Oil did, however, increase 56.7% from the February low of $86.22 to the May high of $135.08 on my chart service’s continuous contract series. That is one big move, and as you know, moves like that often — not always, but often — correct. Also at its May daily high oil rose to a full standard deviation above its regression line, which all things being equal signals overbought territory. Having said that I would love for you to post your sources on demand elasticity, that sounded very interesting. And yes, I too would add to oil sensitive positions on a correction.
Yves is right to point out that Iraq has potentially huge untapped production. In his book, “The Control of Oil,” the late John M. Blair, longtime chief economist of the Senate Committee on Antitrust and Monopoly, documented that BP, which dominated Iraq’s production before its fields were nationalized, actually suppressed information on oil discoveries in Iraq for fear of depressing the price. And as Yves points out, given the small amount of drilling that has taken place in Iraq, potential might even be greater than what BP found before being expelled.
Having said that let’s do the following thought experiment. Suppose Iraq’s oilfields were properly managed for maximum longterm production and fully exploited all along. Let us also suppose that under these circumstances Iraq was now producing 7 million barrels per day and that it could maintain this level five more years. Would the price of oil be substantially lower now? Of course. But given the decline in major oilfields around the world, and the explosion of demand in developing countries, just how long does anyone think the current crisis would have been postponed? I would expect that we would be in the same trouble we are in now, within ten to fifteen years, unless we had done something drastic about developing renewable energy and increasing energy efficiency. Life would be much more pleasant for us but in the grand scheme of things some oil provinces will always experience above ground troubles and relying on finite resources is a temporary strategy at best.
Jonathan, first, here are some studies on demand elasticity for you.
From the University of California, 2007 (my favorite, because it has predicted price well): http://repositories.cdlib.org/cgi/viewcontent.cgi?article=1062&context=ucei/csem
From the Dept. of Energy, 2005: http://www-cta.ornl.gov/cta/Publications/Reports/ORNL_TM2005_45.pdf
From the Congressional Budget Office, 2008: http://www.cbo.gov/ftpdocs/88xx/doc8893/01-14-GasolinePrices.pdf
I agree that Iraq will be producing more oil sooner or later (it’s increasingly looking like sooner). I’m aware that there are unexploited fields in Iraq, and that we will probably get more oil out of damaged reservoirs there. But I don’t see anywhere near 7 million barrels a day coming out of Iraq. BP really did pump the best stuff first, and the embargo caused too rapid pumping, which damaged reservoirs. I see another million to million and a half barrels of oil a day, and I see that extending the supply “plateau” (which is really a slight rate of decline) for roughly an extra year. That’s my best estimate based on current information, including the information from IHT, an outfit I don’t trust because of a long-term record of overstating reserves and production. We’ll see what develops there.
I do understand that the price increase has been extraordinary. But it was produced by extraordinary short-term supply incidents (it was a spike, rather than a speculative bubble). And speculators, who tend to be experienced at reading charts but mostly don’t follow fundamentals closely, are more likely to be shorting oil right now than betting it up. Yahoo has an article up today (“Speculators’ Role in Oil Surge: More than Meets the Eye http://finance.yahoo.com/tech-ticker), for example, that reports on heavy put-buying in the PowerShares Commodity Index, as well as short sellers targeting the major oil companies. They also credit a squeeze on spec shorts as the impetus behind the one-day zoom to $135.
One of the things I’m watching closely is how big the reaction to the new $135 high will be. I’m very interested to see whether we can even get a normal 10% dip out of it. I don’t know that there have been enough speculator longs to get a normal dip.
Regarding your thought experiment, 7 million barrels a day from Iraq (that is, an additional 4.5 million barrels a day over current production) would take the price of oil back down to $50 virtually overnight. It would reset our base point. But then the decline rate and growing demand would start the price moving up again.
For one thing, a lot of destroyed demand would return to the market in response to low prices. (Our efficiency gains haven’t been that great yet–we’ve mostly destroyed demand by squeezing poorer users, like Indonesian fishermen, out of the market.) For another thing, $50 oil would shut down most oil sands production and all deepwater production. The only things operating would be the old wells, many of which now have high decline rates.
Pleasure talking to you.
Moe
Moe and Jonathan,
Regarding thought experiements, do you think the scenario you cite is not what the Iraq war planners had in mind: Iraq a compliant client state of the U.S., a safe and secure environment not only for Iraquis but for U.S. interests as well, U.S. and British oil companies given free rein to explore and produce oil, strategic military bases within the country to exert military domination over the region’s strategic oil reserves?
Of course it didn’t work out that way, but don’t you think that was the objective that was decided upon when Cheny had his little secret junta with other top oil company executives soon after he was elected?
Too bad none of them were students of history:
“War involves in its progress such a train of unforeseen and unsupposed circumstances that no human wisdom can caluclate the end.”–Thomas Paine
“This process of imposing your will on an enemy, of reducing his ability to resist to the breaking point, is rarely–in any war against a determined foe–a quick or simple one. Against a tough foe, only the sustained application of military forces, not sporatic and intermittent attack, is effective.”–Hanson Baldwin
Jonathan, don’t you think where a commodity “should” trade would have less to do with directly associated cash flows than real economy conditions which a commodity is within; whether price efficiently captures this relation and what it most probably will be?
In other words, degree of contradiction which should not presuppose price formation efficiency but allow for social and psychological pressures which may not conform to theories of rational expectations.
Moe, Jonathan or Yves,
Forms of commodity linked structured notes have been around, I believe, since the 1980s; would either of you know how these may have developed over the last years? I vaguely recall a $Libor connection but memory fails.
Questions re. Iraq’s reserves and production potential have been so politicized as to make all claims suspect. Nevertheless, this from July 2007 World Oil:
http://www.worldoil.com/magazine/MAGAZINE_DETAIL.asp?ART_ID=3242&MONTH_YEAR=Jul-2007