Where are we?

Oil is a cyclical commodity that moves in multi-year and multi-decade cycles related to the supply/demand balance.  I believe that the key long-term driver is the industry’s capital investment cycle.  We are following up a period of extreme levels of capital investment in the sector, and I do not believe that the effects of this quite large capital infusion have been fully exploited and utilized just yet, as the assets used for extraction and transmission of the hydrocarbon molecules tend to have very long functional lives.  The charts and graphs below are presented to show where we currently are in the cycle, with context around longer-term inventory and production levels.

United States Production

United States production has grown 130% in less than 10 years, from approximately 5.4MMbbls/d to 12.0MMbbls/d.  Peak Oil Theory suggested that the supposed secular decline in U.S. production was emblematic of a more significant worldwide peak in total production that had been reached, or would be shortly.  The combination and application of directional drilling and hydraulic fracturing to U.S. tight oil deposits appears to have disproven peak oil for the U.S., or at least pushed it significantly into the future.

United States Inventory vs Production

As you can see, over the long run, U.S. inventory levels have been quite stable.  Inventories increased moderately, as prices rose dramatically during the mid to late 2000s.  Domestic inventories hit multi-year peaks in 2010 and 2011, but then exploded much higher in 2015-2016.  Inventory levels dropped as U.S. drilling activity slowed, but remained at historically elevated levels and began increasing again toward the end of 2018. 

United States Imports

The impact of the shale drilling wave can clearly be seen in U.S. imports as well.  The only major exporter to the U.S. to increase shipments to the U.S. during this time was Canada.  Overall, imports from countries with major exports to the U.S. are down 33% from their annual peak in 2005. December 2018 data was not yet available as this post was being composed, so these results will moderate just a bit.

United States Inventory vs Production vs Imports

Combining the trends for U.S. Inventory, Production, and Imports into a single graphic paints a compelling picture of current oil market dynamics and offers a suggestion of how things may play out going forward.  The drastic increase in production and inventories, combined with the dramatic reduction in inventories implies that foreign producers, including OPEC, will be under significant pressure to maintain production levels and market share.

Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

A Time to Gather or Cast Away Oil?

According to The Byrds and Solomon, there is a time to cast away stones and a time to gather stones together; a time to embrace and a time to refrain from embracing.  As Solomon elucidates further, to every endeavor, time and judgment are necessary for beneficial outcomes.  Commodity assets tend to have great swings in value between periods of relatively high demand/inadequate supply and low demand/excessive supply.  Great fortunes can be made or lost on these commodity swings, with time and judgment determining factors in the outcome achieved.

Oil, as the most actively traded commodity, offers perhaps the greatest opportunity for financial gain or loss.  Oil entered a sharp bear market during the summer of 2014 when it began a slide from around $100/bbl to a level in the $40 – $50 range for a sustained period of time.  From the end of 2017 until late 2018, oil advanced dramatically from ~$50/bbl to $75/bbl.   When oil prices were at or near the crest of the decade long bull market from the mid-2000s to 2014, a great deal of the public commentary on the oil price direction indicated a belief that oil prices would remain at those levels or increase going forward.  The commentary now appears to be split between a belief that the oil price will stay lower for longer and projections of a return to significantly higher prices somewhat near those of the recent bull market highs.  The central question facing potential investors and speculators seeking capital appreciation and safety is which of these perspectives will prove to be the most accurate in upcoming months and years.

The case for an extended period of low prices was articulated quite persuasively by Shawn Driscoll of T. Rowe Price in their New Era Fund 2015 annual report released on December 31, 2015:

“As illustrated on page 2, oil prices above $40 per barrel in 2013 dollars are considered unusual in a historical context. Nothing ends a structural upcycle in commodities like high prices, which tend to attract curious and creative minds, technology innovation, and tremendous capital. Charts like the one on page 2 are among the numerous reasons why we believe we have returned to a “new normal” in oil/commodity prices, which looks a lot like the pre-2000 normal, excluding periodic spikes.”

The chart referenced in the quote is shown below.

The chart above shows quite clearly that the oil market experiences tremendous surges in price and, eventually, subsequent crashes/retracements.  A couple of additional characteristics of the market are also visible.  There tends to be roughly decade-long periods of rising or higher prices followed by periods of falling or lower prices. For example, following the price spikes and crashes around the discovery of oil, the price per barrel stayed in a fairly tight range near $20 from the late 1870s until the early 1890s. Prices rose from there and stayed elevated until the early 1900s.  These types of markets were repeated again with low prices until about 1911 and rising prices from then until around 1921.  Prices at or near the $100 mark in 21st century dollars are extremely rare, having occurred only 3 times since 1861.  The lower-for-longer school of thought espouses that the recent price spike is more of a historical anomaly than a new price paradigm and that the price per barrel will most likely settle in closer to the long-term average price of $30-40 bbl.

The second school of thought purports that recent bull market prices are more indicative of future price action, especially in the intermediate term, than historical price charts. In a recent market outlook update, Raymond James’ Pavel Molchanov advocates for a cyclical peak price of $93/bbl in 2020, with a normalized price of $75 following. This outlook is predicated primarily on the perspective that the market’s supply capabilities are insufficient to maintain current inventory levels in the short-term and a higher long-term price as necessary to support supply functions.  I believe this to be a representative expression of this second school of thought.

Inherent in the assumptions of this line of thinking is that something fundamental has changed about the markets to necessitate a higher price than the long-term average.  Given that two of the three price surges above $100 bbl have occurred in the past 45 years and that prices were significantly higher than the long-term average during much of this time, questioning the viability of very long-dated price estimations is indeed valid, but it is my belief that the lower-for-longer assumptions most confirm to reality. 

If this is indeed the most correct market perspective going forward, oil price volatility to the upside can provide opportunities to make very nice profits by shorting oil, as the prices correct to trend.  The New Era Fund’s 2018 annual report mentions $40-50/bbl as a likely long-term average price range, which  appears reasonable given oil’s price moves over the past 3-4 years.  If price approaches or exceeds $60/bbl, I believe that oil becomes an exceptional short opportunity by use of ETFs or futures options.  A price decrease of $15, from $60 to $45 provides a move of 25%, with the potential for much more if a test of the 2008 and 2016 lows at or below $30/bbl are achieved.

Happy Fishing!

Disclaimer: I currently own shares of OILD, an inverse oil price ETF

I am not a financial services professional. All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.