The oil price bet

January 1, 2019 at 1:19 pm
Contributed by: Chris

In December 2014, I made a bet with Ed Crooks of the Financial Times about what oil prices would do in 2015. (Perhaps at some point I will recount the details of that bet, as well as the other oil bets I participated in, going back to 2009, on which I have kept notes but never written about.)  

On Twitter, that original wager grew over the years into one that had 24 participants in 2018, as detailed here by Leslie Hayward, who has graciously acted as the neutral bet-keeper and reporter of the competition. The rules of the bet are here.

I decided to create this page to host my thoughts about the bets and my rationale for my price target each year, because I find it instructive to look back and reconsider my outlook at the beginning of the year, and compare it to what actually happened. (Oddly, this useful practice is very rarely observed by the hundreds of professional oil pundits.) As time and interest allows, I will occasionally update it with more details.

2019

The official bets are here with a record 34 participants! 

Summary post by Alex Adams at SAFE about the 2018 and 2019 bets.

My rationale (written 1/1/2019)

I didn’t have a lot of time to devote to thinking about the bet this year, but I am reflecting on the fact that the price of oil became highly correlated to the broader market in Q4 2018, closely following the performance of everything from the S&P 500 to individual tech stocks. To me, that indicates that the oil price action had ceased to be about the fundamentals of the oil trade. (For a view of the factors I typically consider for oil prices, have a look at my 2012 post, “A model of oil prices.”) The broad narrative about weak demand across the global economy suggests to me a recognition of much larger and more basic bearish forces, as I wrote about in “Economic theory and the Real Great Contraction” and “Occupy, Tea Party, and the Politics of Less.”

My concerns about oil supply have not changed. Look around the world and the number of suppliers who can meaningfully increase production at this point are few indeed: Saudi Arabia (maybe good for another 1 – 1.5 mb/d), a few hundred thousand barrels a day from a handful of other OPEC countries, Russia (a little bit, maybe, but not more than 1 mb/d in my opinion) and the US. Where most of those suppliers have other constraints, like OPEC production quotas and fiscal budget concerns, that will have as much influence on their output as global demand.

The US tight oil complex is really the only place where significant (over 1 mb/d) new supply could conceivably come from, but if you look closely at it, it becomes apparent that essentially all new production growth would have to come from the Permian Basin. Eyeball the charts by production basin in the EIA’s DPR: Outside the Permian, there’s been about a combined 300-350 kb/d growth above the previous 2015 peaks in the Anadarko, Bakken, and Niobrara, which has been basically netted out by the below-peak production in the Eagle Ford. So all of the growth in US tight oil above the previous 2015 peak has been in the Permian. And while the some of the other basins are still showing some growth, it’s not particularly strong, and there are contravening indications in some of those plays that they may be finally hitting the saturation point where additional drilling only beggars existing wells through communication between closely-spaced laterals. (I have a theory in which the Permian is actually the only significant potential source of growth in oil production worldwide at this point, but that will have to wait for another day…)

But, as I said, all of that is basically irrelevant when correlations go to one across multiple market sectors globally. That basically tells you that supply-side factors are exerting less influence on the market than the demand-side ones. It also tells you that trading phenomena, like hedge funds raising cash to cover liquidations, short-covering, algos gone wild, and other things that have nothing to do with the underlying value of an asset, can utterly swamp the trade. 

So when I look out over 2019, I see a lot less of significance to consider in terms of fundamentals than I did for 2018. Technical analysis says that the stock market officially entered bear market territory in late December, ending the longest bull run since 1945 (maybe ever? I haven’t run the numbers). And bull markets usually take awhile to reverse course. Plus, there are many reasons to think the equity markets have become wildly overvalued and are poised for a very steep correction. 

Therefore my call for 2019 is that it will be dominated by concerns over weak demand, producing a bear market for both equities and commodities. As a consequence, oil could see valuations  that are too low to make sense on the fundamentals of production cost, as they have twice over the past decade (in Q4 2008 and Q4 2015 – Q1 2016). 

Which makes forecasting the price all the more difficult. I had some pretty good fundamental factors to guide my price forecast in 2018. This year, not so much. When you’re in macro territory, prices are pretty much a crapshoot.

So here’s how I’m approaching it: Prices are likely to end 2019 lower than where they were at the end of 2018 ($53.80). But there really isn’t much legroom below $53. I haven’t tried to get current data on global production costs lately (because it’s hard to do and I don’t have the time for it) but it looks like $50/bbl is a reasonable guess at a floor for most of the world, with maybe some tight oil sweet spots in the US below that, and much of the marginal supply well above that with breakevens of $65 or better, as I detailed in my 2018 rationale. So I would be inclined to guess that Brent ends 2019 around $50, unless there is a really sharp correction into oversold territory like we saw at the end of 2008. 

But then I have to consider how the other bets will fall for 2019 in what is sure to be an even more crowded field. I’m guessing there will be a pretty good cluster around the $50 point, and I’m not confident enough about $50 to try to battle it out there. So I’m going to aim just a bit lower, to $47, just because I like the number 47. (No, really. That’s why. A sad and ignominious bet, but that’s where I landed.) Also, I don’t think there will be a lot of bets below $47 but I see a pretty strong weighting of risk that could lead to prices below $47, so I think my odds are good there. 

If the health of the markets returns, and demand starts to look strong again, or if there is intensified production discipline within OPEC or even within the US, then I think the trade could get refocused on supply-side factors and the price could start moving back toward the $81 target I chose for 2018. But right now, those seem like low-probability events for 2019. (And if/when demand does start to drive the trade again, we could see an unprecedented price spike, because the oil industry will have spent over 5 years under-investing in future supply and spare capacity will be next to nothing.)

May the best man or woman win!  

2018

The official bets for 2018 are here.

My rationale (written 12/30/2017)

I see a lot of price-bullish factors and am hard-pressed to think of many significant price-bearish factors. I suspect that most others on the bet will be thinking conservatively and timidly and will be reluctant to bet above $75. I think if I take $80 I’ll have a pretty good shot at the entire high end of the potential price band, and if I take $81 I’ll be likely to beat any other bullish bets which will probably top out at $80. My guess is the actual price at the end of 2018 will be over $80 – maybe $82 or so. The last time Brent was there was during the rapid crash from $112 to $53 in 2014. That whole price band needs to be properly retested against actual current fundamentals. So I think we’re going to leave the “Goldilocks” period behind, and return to a strong oil market where prices are high enough (e.g., holding above $65) to sustain upstream E&P (not just in US tight oil, but in deepwater, projects like “Cash-Again” and other expensive mega-cap projects).

Price-bullish

Upward momentum: Strong, steady 50% run-up from $44.82 on May 21, 2017 through to the end of year close at $66.63.

Demand still growing: IEA (as of Dec 14, 2017) forecasts 1.5 mb/d growth in 2017 over 2016.

Supply constrained: OPEC ‘n friends still seem to be holding to their production cut discipline. Total output right now is down 1.5 mb/d from a year ago. IEA believes commercial stocks fell in every quarter of 2017, with current inventory of 2,940 mb, 111 mb above the 5-year average and the lowest since July 2015. I don’t see any material new supply coming in 2018 from Russia or Iran. Iraq might (as might US) but that could be balanced out by declines in VZ, Brazil, and general mature field declines. Non-OPEC supply should have risen by 0.6 mb/d in 2017 (during the 50% price rise!) and could rise 1.6 mb/d in 2018 but most of that is tight oil, on which I am skeptical.

Tight oil outlook is weak: Investors are beginning to demand actual returns and are likely to be less willing to keep pumping debt into the sector until it shows real profits. If the tight oil patch has to start drilling out of cash flow and not fresh debt, it would dampen its ability to quickly ramp up in response to further price increases.

Investor sentiment: Oil & gas as a sector has been hated for several years now while equities have made a huge run. The S&P is up 300% since the 2009 low and is now just 8 months short of being the longest bull market since 1945. Share valuations are historically high and lots of observers are calling it bubblicious. There’s a chance that the market is ready for a sector rotation.

Interest rates may climb again after Yellen’s 12/13/17 announcement that they’ll hike another 250 bp. That would likely reduce investor appetite for risk equities and possibly drive money back into the oil patch.

Upstream investment has been starved for three years now and if demand starts to look strong again, it could set off a bit of a panic as people realize how little fresh capacity is in the pipeline.

Geopolitics: New unrest and protests in Iran. Royal turmoil and possible future instability in the House of Saud. Possible rifts in old alliances between UAE, KSA, Qatar. Trump could instigate a war.

Forties pipeline crack will take 300-400 kb/d off the market for a time, but that probably won’t be a material influence on price a year from now.

Price-bearish

Demand growth isn’t super strong and could weaken, especially if China is more or less done filling its SPR (an x-factor no one has ever figured out how to value).

EVs could cut into demand expectations but there’s no reason to think that’s actually happening yet…or exactly when it will become a significant factor. But mere expectations of reduced demand could dampen prices long before actual demand is depressed.

The sector is still out of favor and there’s no clear indication yet of a rotation back into it.

The results

Oil prices followed my expectations beautifully for the first three quarters of the year, with Brent rising from $66.57 on Jan 2 to $86.74 on Oct 3. My $81 bet looked like a lock. But then several factors conspired to change the outlook entirely, neatly summarized here by Collin Eaton, and Brent posted the first year of losses in three years, ending at $53.80 and making S&P oil reporter @BrianJScheid the winner of the 2018 bet by a margin of $0.59 over Axios’ Steve Levine… almost as narrow a victory as my 2017 win, by $0.26, over Columbia University’s Jason Bordoff. While my main price-bullish factors, such as concerns over constrained supply (including a quite modest performance from US tight oil plays) did appear to drive the price action for most of the year (at least in narratives offered by the professional pundits) the weakening economy (my number-one price-bearish factor) ultimately emerged as the most prominent driver of the price action in Q4. 

It was classic “escalator up, elevator down” action and that usually signals one of two things: Either the security or commodity was in a bubble that popped, or the trade is being driven by something exogenous. It was the latter that informed my 2019 bet. 

 

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