INSIGHTS

On December 08, 2014

Crude’s Correction and Commodity Capitulation

The recent sell-off in crude oil prices may be attributed to one or all of the following:  basic over supply, concerns about global deflationary and recessionary pressures, OPECs futility, America’s energy route to independence or even the cold fusion breakthrough from Lockheed Martin.  (The cold fusion breakthrough should have come with more details, a basic cold fusion primer on the actual process needed for cold fusion and lastly, a tin foil hat.   The promise has always outweighed its practicality, and with limited research one can understand why.)  The most experienced minds point to 2050 as the earliest domestic rollout, but hey, a company can dream can’t it?

The price of oil has thrown some substantial monkey wrenches into the period where everyone uses baseline estimates in a magical formula to spit out exact “ranges” of economic growth.  A drop of 30% has had an impact so that economists and strategists are working overtime to recalculate their numbers.  The decline may actually spur a spike in demand for energy which may make their calculations even more off….thus, a vicious cycle of minutia adjusting.

The oil discussion should start with the changes seen over the last 35 years.  We have moved to better technology that is discovering new fields at near hyperbolic rate.  Even with exhaustion of these fields proving to be faster than historic levels, there is still quite a huge net gain annually.  The changes within the two years of the EIA’s (US Energy Information Administration) research display this:

The last 35 years has seen a shift to “consumer regulated” pricing.  Meaning, when prices become too high, consumers shift behavior and carpool more, drive less, etc.  When prices drop, demand picks up.  The old adage that high oil prices kill high oil prices has never been more true.

 Though the market is dominated by news that demand has declined, supply has increased and OPEC is not administering a cut, there are some reasons that indicate we are near the bottom and could see prices rise in fairly short order.

• The Economist predicts that a $30 drop in oil brings about a shift of nearly $1.3 trillion from producer to consumer cost savings.
• The last time the price of oil dropped so substantially (2008), we saw demand increase of over 2 million barrels per day.
• From a crude perspective, the US saves $334 billion annually from its 2014 high price of $115.06 to its current level of $66.47.  This is exacerbated, but the number is substantial.  Europe could see slightly less of an impact, but it would still be significant for a region that is mired in recessionary pressures.
• According to IHS Inc. and the Economist, the typical project break-even cost has dropped in the last year from $70 a barrel to $57 a barrel.   To put this in perspective, consider an article from Business Insider (http://www.businessinsider.com/citi-breakeven-oil-production-prices-2014-11 ) that discusses break-even prices for projects around the world in 2020.  I have updated the chart (below) to show an estimated red line of current oil prices, but as you can see there is more pressure to wind down some areas and maintain others for a little while, with the hope that prices increase.   The research from the article was taken from Ed Morse, Managing Director and Global Head Commodities with Citigroup.  As a side note, I would strongly recommend reading his team and his research if possible.    

Source: Business Insider

One report we like to cite is the Bank of America Merrill Lynch Global Fund Manager survey.  As the November one has yet to come out (usually released in the middle of next month) the report from October showed an interesting perspective on oil.  Recall, when this was done, oil was still in the mid $80’s.  The level of global fund managers believing oil was undervalued hit a level not seen since the spring of 2009.  Consider what occurred in crude in the following one and two year periods.

The last thing to discuss is the timing of an increase in oil prices.  While I think the current trading environment points to limited downward pressure, the long-term seems to point to a level of long-term basing.  The commodity trading market is seeing what we have been witnessing in the fixed income arena.  Consider that over the last few years, we have seen reductions or the outright elimination of commodity trading desks from a large number of financial institutions.  With fewer participants and increased regulatory pressures, price movements may be exacerbated in both extremes.  Downsides may be further than what fundamentals and history explain, however so too may be the increase in prices when demand begins to drain excess supply.  Just as high oil prices kill high oil prices, lower prices have the same impact.  Eventually we will find equilibrium, until then, hold on tight to the saddle. 

CRN: 2014-1208-4552 R

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