The Hydro Carbon gnomes in Switzerland! Have we seen the bottom of the oil market and how strong should we expect it to get from here?
Only madmen (and mad women, of course), charlatans and economists believe that they can forecast oil prices. If they could, it would be a perfect (as in ‘perfect market’ – a state of existence not created by God but dreamt up by economists as an aid to teaching the subject) oil sector, which it is not.
If they could even fairly reliably forecast the future price of oil, you would not have a top analyst, of a top investment bank, at the top of the oil market in 2014 – earning, no doubt, top dollars – pronounce that the price of oil would keep on rising up to, I seem to recall, an estimated $200 a barrel, just before it started its big slide downwards. Big salaries guarantee neither correct forecasts of oil prices by analysts nor goals by Premier League footballers. Foretelling oil prices is the highly democratic game of informed guesswork – just like backing horses. Being informed does not make it a science.
I write these cautionary observations because we have just had reports from the great jamboree of crude oil specialists in Lausanne, whose observations sent equity markets into cartwheels of happy bullishness. BP (BP.) was up 2.6% in a few hours to 366.25p. One can almost feel through the very ether, misery, pessimism and gloom lifting off into ecstasy, optimism and joy. For more than one reason, we are all in the mood for good news from somewhere. This is the rich soil in which giant beanstalks and magic mushrooms grow. So keep the feet on the ground (not up the bean stalk) and the head clear of magic mushroom hallucinations (as required by the law).
The basic rule about crude oil prices is that they are volatile and thus often unpredictable. We have all had enough recent evidence of commodity volatility.
What came out of Lausanne from the assembled oil barons and hydro-carbon gnomes, no doubt enlivened by bubbles of champagne, was in fact a rather vague, woolly and qualified optimism. Not the high expectations of intergalactic rocketry. The essential message seems to be – and even that of course is not subject to guarantee – that we probably saw the bottom of the market in crude oil prices when the price of the stuff went below $30 a barrel for Brent and, probably, also West Texas Intermediate (WTI), which is currently a dollar or two behind the Brent price. (The exportation of crude oil from the US is beginning to merge North American crude with the rest of the world’s oil markets.)
Accepting that as about as reliable an informed guess as you are likely to see, what may we reasonably build on that in the way of even higher prices? Something less than $100 a barrel, I presume.
First we should look at what the suppliers and processors are said to need, on the basis that what big powerful institutions want is what they work towards. It is reported that a Mr Igor Sechin of the Russian oil producer Rosneft and the Kremlin stated that he wants a price higher than $50 dollars a barrel. That is obviously a hint to his Saudi Arabian and OPEC chums. Is that likely to happen? Much depends on the complexity of Saudi political and diplomatic desires in the short to medium term.
The “Kingdom” as they call it – as though it were the only such organisation in existence – remains in a state of mutual regional rivalry, religious civil war and diplomatic mistrust with Iran. That appears to be part of its reasoning for keeping its crude oil pumps open and seems likely to remain a relevant consideration over the short to medium term. The Saudi state is short of money in a way that it was not a few years ago, when it was still playing oil monopoly, in which you sacrifice control over production for control of the price. But it has the capacity and plans to borrow the money it needs internationally to see it through. China has plenty of money and gladly invests in low oil prices.
Elsewhere from within the Lausanne club, there was reported talk of $60-70 as being the equilibrium price at which the likely maximum demand for oil will produce the necessary supply to meet it. One can only assume that such an estimated calculation includes a realistic contribution from a newly unchained supply from Iran that suits Saudi Arabia as well as everyone else.
Looking at what seem to be the basic economic assumptions being made about the future of oil and its price, we see that the growth of India in GDP terms has prompted some of the number crunchers to conclude that demand for oil this year will increase sufficiently. That is buttressed by the fact that China’s demand for oil has held up better than expected, with its increased economic activity in civil aviation and the use of motor vehicles etc.
On the oil production supply side, we have reached the time when the recent jump in the production of US oil is visibly being pulled back. One statistic I note is that the employment of rigs in US oil production has fallen by 44% over the last 12 months. There is clearly a steady and strong run down in both US oil exploration and production.
The more volatile and mysterious part of the equation – oil inventories or stocks – are reported to be to be in decline. However, it is the speed of that process that is the most share-price sensitive component of demand, and media stories of a quickening or slowing in oil stocks will govern sentiment towards oil shares.
The other current assumptions being made are that Libya, by courtesy of the vacuum into which the fascism of ISIS has moved along with a variety of other civil war problems, will remain too much of a basket case meanwhile, to be an obvious or reliable supplier of crude oil; that the Iranian oil industry will take some time to be brought up to fuller production, after years of inactivity and neglect; that much of the older and traditional oil producing estate is also in need of a lot of remedial attention to enhance its productivity; that Russian production will not rise because they have been selling as much as they can over the last year or so in order to maintain revenue; that big international oil companies with shares quoted on stock exchanges have spent the last year cutting production significantly; and finally, of course, there is technological competition in the form of new renewable energy supplies.
In short, there is plenty of evidence to suggest that the balance of risk/reward has repositioned itself more towards reward and away from risk – at least enough to permit us the optimism to believe that the oil price may indeed be moved towards an upper range of between, possibly, $60-70 a barrel. But that does not seem enough evidence to reasonably believe that the oil price will head for the $100 a barrel of recent, cherished memory.
For share selection purposes much will depend on the extent to which oil companies have, one way or another, reduced their cost bases to take advantage of somewhat firmer prices. We know that the big companies have had the flexibility to do a lot to reduce their previous breakeven costs. For a company like BP, for example, a move up to even $50 a barrel should do wonders for its depleted cash flow and thus its dividend prospects, which looked bleak a month or so ago. In the case of BP it has coincided with what seems to have been the final curtain call on litigation costs of the Gulf of Mexico debacle with the US government, if not yet with some civil actions.