5/25/09 – Memorial Day
On this Memorial Day 2009 the flags are flying, the birds are singing and, I hope, all is right with world.
2008 was a year that caused a lot more than just pondering about oil prices in the energy industry and especially by consumers and government. Who would have believed back on July 11, 2008 when we saw $147.27 oil that only 6 month later oil would trade at $33.87 of December 19, 2008, a level not seen since 2005? Of course, who would have believed on the first trading day of 2008 some fool would have paid $100.01 for one oil contract? While it took a little while into 2008 to make $100 a base that during the first half of the year a fond memory, who would have thought that oil would increase by another $50 in less than 6 months? Nevertheless, coincidentally oil averaged $99.75 for the year. Was this just a coincidence to the starting point?
Now we see a recovery in prices from that low to over $60. This movement not only reflects a rebound form the overcorrection that drove prices to those lows, but a belief, or speculation, that a recovery from the current financial crisis will bring back demand.
I use the term speculation in that the global economy remains weak and the outlook for such a recovery could take quite some time. Yet, hope springs eternal, or in the words of the writers of Boston Legal, “Hopes springs a kernel” for our ethanol friends, and as the stock market is showing signs of life, oil prices are marching along in lock step. This is seen in the futures market with its large cantango that he non-physical players are using even in the face of high inventory levels.
The cantango is also supported by the fact that the energy industry has dramatically curtailed new projects and drilling. The lead-time required to bring production back on line will result in a real supply squeeze and in turn yet a new price spike, overcorrecting from this past winters lows. That spike will lead to the next overcorrection, confirming my observation that prices are not mean reverting, but have a revulsion to the mean.
A spike, by definition, will not last very long. Counting on high prices to remain would be foolhardy and lead to misplaced investments.
I repeat the chart in Step – 7 of my report here to support the rest of this discussion. In spite of the above observations, I have not changed this forecast. This is the benefit of probabilistic forecasting and using a very wide distribution at that.
So what is volatility really? The range in the above forecast is fro $20 to $200. Yet slow price movements over this range, while of concern, would be worked into the economy. From Step 3 in my report I offered a technical point and figure chart of oil prices. The trading ranges were quite well defined. The short-term price movements, normally defined as volatility, are seen to be quite stable.
Perhaps $100 swings are just a new and standard level of volatility, and we better get used to it and the price swings in petroleum products (gasoline) that such movement brings.
Technical Analysis (Step 3 in Confessions of an Energy Price Forecaster) is a way to measure how the markets are signaling the future direction of price.
In July we even had one analyst shop predict $200 oil. I even included $200 at the upper end of my probability distribution of prices. It’s there with a very small probability of occurring, but it is there. While I will not remove this remote possibility of $200 from my forecast, that analyst shop has closed for now as they have given up making energy price recommendations for their clients.
Of particular current (Oh, if we would only remember history) interest was the breakout seen in July peaking intraday at $147.27 and the recent collapse to an intraday low of $48.5 on Nov. 20. While the upward spike of this past summer was not a total surprise, the correction has been unprecedented in terms of its magnitude.
The last gasps of the long-term run up were certainly signals of a runaway global economy fueled by demand from Chindia, extremely low interest rates and a weak dollar, to name but a few factors tugging on price. The perfect storm of these high commodity prices along with these same factors helped kick off the current financial crisis. With nobody buying anything, of course, commodity prices had to collapse.
Typical violations of these technical trends are signals for a potential change in the fundamentals driving that market and, therefore, in future trading ranges. This was seen in 2000 with a fairly orderly shift to the upward trend fro 2000 to mid ’08. However, while the magnitude of the current correction is certainly some kind of very strong signal of change, where we are going is indeed a point to ponder.
All the news we hear today about our financial crisis has the analysts shaking there heads as the S&P 500, the Dow, stocks like GE and GM, etc hitting lows that have not been seen in years if not decades. Many of these analysts were not even a twinkle in their parent’s eyes when such prices were last seen.
- The real point to ponder is that such extreme changes are not conducive to offering insight as to future direction. Again, as President elect Obama has promised change, let us pray to give him insight and wisdom for that change to be a viable turn around in this downward correction in the economy even if such a turn around may increase commodity prices.
Points to Ponder
- The real issue is to find out is was the low of $33.87 a final capitulation in this price correction in the same manner as investors are looking for the final capitulation in the stock market.
- Does the current $60 represent a fundamental price level that the current economy would defend as basic supply and demand?
- How high do you think the spike will be, how long will it last and when will that overcorrection from the current lows swing prices back? This will be a function of how long it takes the economy to burn off the excess inventory, estimated to be about a total of 65 days in onshore storage plus the indeterminate amount in tankers waiting off shore to bring their cargo to market and the ability of the decision makers in the production side of the industry to read these tealeaves and start up the investment pump.
- Oil price spikes and recessions have gone hand in hand albeit the timing of the spikes relation to the recessions have been somewhat varied. Which is the driver, the spike or the recession?
- In a pure competitive free market, price would revert to what would induce to highest cost producer to supply the next unit of production. Oil entering the market would then cover the cost of all production (with to lowest cost always at full production). However, there is a lag in the time it takes for decision makers to realize this. Even the past administration was filling the SPR at $145. Where was the buy low and sell, I mean, use this source when there is a crisis that drives the prices high? Was there real worry over prices going even higher?
The inability to read the tealeaves causes this overreaction. Along with other transitory issues, the oil markets are left perpetually unstable. If only the decision makers would take the time to see more than the current situation and consider what might happen. That would not necessarily lead to better decisions, but at least they would be informed decisions.
- OPEC quotas in the name of supporting price curtails low-cost production leaving high-cost global supply in an over production mode. In most cases revenue needs and not the next marginal barrel drive OPEC. However, with OPEC cheating (See Points to Ponder -- OPEC’s Floor Price 11/27/08) the Saudis hold 70% of a diminishing global excess capacity. Will OPEC resist the temptation to try to drive prices higher in light of the global recession?
- How much of current geopolitics are now in base price of energy or are they still a transitory factor?
- When low prices had been seen in the past the producers realized that while their bottom line was hurt, the competition from higher costs sources were totally uneconomic.
Therefore, if new higher cost sources are to be pursued in this market, even at $60, they will require extended and larger subsidies or be delayed. To compound the situation, reigniting investment in conventional energy also faces the quandary of future governmental taxation and regulation. This in turn will only generate new revenues for government, if the spike in prices is so high as to create at least a temporary windfall of profits.
- Do the current round of layoffs in the energy industry lead to “high grading” of talent?
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