Stop wor­ry­ing and learn to love cheap oil

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In al­most ev­ery fi­nan­cial cy­cle there comes a point when the pub­licly ex­pressed views of an­a­lysts and in­vestors di­verge com­pletely from mar­ket be­hav­iour. Oc­ca­sion­ally, this can be what Ge­orge Soros has called a mo­ment of truth, when in­vestors sud­denly re­alise that a fi­nan­cial boom has wildly over­shot eco­nomic fun­da­men­tals and is about to turn to bust. But of­ten it turns out that the mar­kets have grasped a mes­sage that has not yet been con­sciously un­der­stood by in­vestors — and it is an­a­lyst ex­pec­ta­tions that ul­ti­mately have to ad­just.

Mon­day may have a marked such a mo­ment in the oil and com­mod­ity cy­cles and their in­ter­ac­tion with the world econ­omy. Although the col­lapse of oil prices be­gan more than a year ago, in July 2014, most energy ex­perts, rang­ing from in­vest­ment an­a­lysts and in­vestors to OPEC min­is­ters and “big oil” ex­ec­u­tives, have been in de­nial about the fun­da­men­tal po­lit­i­cal, driv­ing this mar­ket rout.

Even the prospect of Iran’s re-emer­gence as the world’s third big­gest oil ex­porter, which was al­most guar­an­teed to cause the next down­ward lurch in prices was ini­tially dis­missed by many an­a­lysts as a mi­nor fac­tor that would take un­til 2016 or even 2017 to af­fect global sup­ply and de­mand.

But Mon­day may have been a mo­ment of truth when in­vestor ex­pec­ta­tions be­gan to catch up with re­al­i­ties that many energy an­a­lysts have found it dif­fi­cult (or un­bear­ably ex­pen­sive) to ac­cept. A shift in psy­chol­ogy was sug­gested by the way that eq­uity prices stead­ied and then ral­lied in New York, even as oil prices closed on their lows. This mar­ket be­hav­iour, if it con­tin­ues in the days ahead (a big “if”, of course), may im­ply that in­vestors are no longer treat­ing the col­lapse in oil prices as a lead­ing in­di­ca­tor of global eco­nomic weak­ness and in­stead may soon start to recog­nise cheap oil for what it has al­ways been and still is to­day: a very pow­er­ful

eco­nomic

and

ge­o­log­i­cal

forces stim­u­lant for global growth.

One rea­son in­vestors have been slow to recog­nise the macroe­co­nomic ben­e­fits of low oil prices is the state of de­nial among energy ex­perts about the oil mar­ket it­self. This phase of de­nial may also now be end­ing, as energy in­vestors recog­nise the eco­nomic and po­lit­i­cal fun­da­men­tals that are likely to keep oil prices low for years ahead, even if the world econ­omy ac­cel­er­ates strongly, as it did af­ter the oil price crash of 1986:

1) Global oil sup­plies clearly ex­ceed the prob­a­ble growth in long-term de­mand. This is a con­se­quence of po­ten­tially un­lim­ited sup­plies of shale oil, not only in North Amer­ica but also in Ar­gentina, Rus­sia and China. Mean­while, on the de­mand side, steady re­duc­tions in the oil in­ten­sity of eco­nomic growth are in­evitable be­cause of en­vi­ron­men­tal reg­u­la­tions and tech­no­log­i­cal ad­vances that are rapidly im­prov­ing the eco­nom­ics of so­lar, wind and bat­tery power.

2) The com­bi­na­tion of tech­nol­ogy, pric­ing and reg­u­la­tion above means that much of the oil that has al­ready been dis­cov­ered will never be pro­duced and in­stead will be­come a “stranded as­set” sim­i­lar to most of the world’s known coal re­serves. This means that search­ing for new oil re­serves in high cost lo­ca­tions such as the Arc­tic and deep oceans is a mon­u­men­tal waste of money and a mis­al­lo­ca­tion of cap­i­tal that makes sub­prime prop­erty look like a pru­dent in­vest­ment wor­thy of War­ren Buf­fett. Yet drilling for oil in chal­leng­ing lo­ca­tions is what many oil com­pany ex­ec­u­tives still re­gard as their core com­pe­tence.

3) Now that Saudi Ara­bia has re­alised that its oil re­serves will be­come a stranded as­set if it al­lows other pro­duc­ers to squeeze its mar­ket share, the oil trade has been trans­formed from a mo­nop­oly or oli­gop­oly into a more or less nor­mal com­pet­i­tive com­mod­ity mar­ket. Saudi Ara­bia or OPEC can no longer set a price and then de­fend it as that would mean cut­ting back Saudi pro­duc­tion con­tin­u­ously to ac­com­mo­date the in­creas­ing amounts of new oil that can be pro­duced, even at high prices, in North Amer­ica in ad­di­tion to that which will again soon be avail­able from Iran and Iraq, and even­tu­ally also Rus­sia, Libya and Nige­ria.

4) Geopo­lit­i­cal and se­cu­rity con­di­tions are al­ready so bad in many oil pro­duc­ing re­gions that mil­i­tary and po­lit­i­cal changes in the years ahead are likely to be con­ducive to more oil pro­duc­tion, not less. And since prices are made at the mar­gin, geopo­lit­i­cal sur­prises should now be viewed mainly as a ma­jor down­side risk to oil prices.

5) As a re­sult of the points above, oil prices are now de­ter­mined by sup­ply con­di­tions much more than by de­mand. This is an im­por­tant point about com­mod­ity pric­ing gen­er­ally that An­drew Bat­son has dis­cussed in his work on China and iron ore. It means that ris­ing and fall­ing prices should no longer be con­sid­ered a lead­ing in­di­ca­tor of global or Chi­nese GDP, but in­stead mainly as a func­tion of sup­ply con­di­tions and pro­duc­tion costs. Fluc­tu­a­tions in global eco­nomic ac­tiv­ity or Chi­nese growth will have only a mi­nor ef­fect on oil prices in fu­ture, com­pared to the large swings in sup­ply dic­tated by geopo­lit­i­cal events such as the Iran set­tle­ment or an end to Rus­sian sanc­tions and the chang­ing eco­nom­ics of shale.

6) Since oil is now priced in a more or less com­pet­i­tive mar­ket and US shale drillers have be­come the swing pro­duc­ers, the mar­ginal costs of US shale pro­duc­tion should be seen as a ceil­ing, not a floor, for the long-term price of oil. With frack­ing tech­nol­ogy ad­vanc­ing and in­tense com­pe­ti­tion now forc­ing pro­duc­tion costs and wages down­wards, that mar­ginal cost ceil­ing is turn­ing out to be much lower than the $70 or so that many an­a­lysts pre­dicted—and it is more likely to fall than to rise in the years ahead.

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