October 28th, 2014
It Is When, Not If, Oil Breaks $70
by Andrew Butter
Since mid 2010 the oil industry was getting used to Brent averaging around $110. From then to mid 2014 share prices of Halliburton (HAL) Schlumberger (SLB), Hercules (HERO), Transocean (RIG) etc, went up by average 250%. By way of a benchmark for the collective enthusiasm in the idea of the irreversibility of Peak Oil, MODU (jack-up drilling rigs) utilization and day rates climbed into the champagne-all-round arena. According to IHS, a consultancy, there are 118 new ones being built so as to complement the current worldwide fleet of 550.
About 40% of those are in China thanks in part to the 5% you used to be able to put down grace of the beneficence of the Bank of Chairman Mao...which incidentally has the smell of the dry bulk carrier enthusiasm seven years ago, also largely financed by the Bank of Chairman Mao.
Then the darn "market" threw a wobbly.
Thankfully there are some excellent explanations for why that happened:
- A cunning terrorist plot to undermine America, Freedom and World Peace
- Sunshine in Moscow and rain in Riyadh
- Electric cars
Here's one more. There was a bubble...and it popped.
This isn't the first time since 2010 that there was a "scare". In mid 2012 Brent dipped to $90 before bouncing back just after I pronounced it would go under $70 and stay under $90 for a couple of years: http://www.marketoracle.co.uk/Article34980.html. Then in March 2013, same story... http://www.marketoracle.co.uk/Article39075.html
That was my third wrong-call on oil. I'd said pretty much the same thing in 2011. Be that as it may, calling the timing of the collapse of a bubble is almost impossible; it's all about when the collective consciousness does an about-turn and/or the soon-to-be losers and their banks have irrevocably over-committed, like perhaps the beneficial owners of those 118 MODU's. George Soros gets a pain in his back when a bubble is about to pop, and I put my back out in July. Perhaps that was a sign, just I didn't join up the dots?
So at risk of getting nominated for the Nouriel Roubini Broken Clock Award, I'm still saying that since mid 2011 oil has been in a bubble and one day Brent will go down below $70 and stay under $90 for as long as it was over $90.
In 2011 and 2012 no one knew how well the new technology for extracting oil from shale would work. In the event it worked very well, also at a price of $100 combined with the memories of the talk of Peak Oil, investment in upgrading old fields and looking for new ones skyrocketed. What's changed since 2011 is the money that got put on the table can't be taken back, so now, even if the price goes to $70 or less and the marginal cost of production in a new or re-vitalized well is $75, likely the banks will insist the oil that cost $75 to get is pumped, rather than waiting for the price to bounce. Meanwhile OPEC and other incumbents will keep pumping until anyone mad enough to develop an oil well that produces at a cost more than $75 will be either bankrupt or on intravenous government-funded life-support. When the last of the losers are wheeled away, prices will recover to the correct level, which currently, according to my calculation (below), is about $90 (Brent).
When that process starts is hard to call. The evidence from the share-prices of the oil service companies would seem to suggest that as we speak, there is a collective re-thinking of how much good money to throw after bad.
How can anyone say there is a bubble?
By definition, when a bubble is in play, everyone except a few odd-balls believe in the infallibility of mark-to-market, and that in a free-market, value is simply the price you can sell something for, to someone dumber than you. That philosophy is a common cause of bubbles, as is explained here: http://www.marketoracle.co.uk/Article8177.html
The only way to really know there was a bubble is when it finally collapses and the investors who believed otherwise either go broke or get bailed out. That hasn't happened yet - until then, it's all theoretical:
The General Theory of the Pebble in the Pond
The theory so far: (A) Everything has a "fundamental" value, including oil (B) a sustained departure in price from the fundamental one way must inevitably be followed by an equal departure the other way, because (C) bubbles are zero-sum, the windfall of the winners is exactly equal to the size of the empty pockets of the losers...like when you throw a pebble in a pond, the peaks of the waves that are created are exactly mirrored in the troughs, the net result is that the average level of the pond is unchanged.
Of course everyone disagrees about what the "fundamental" value is. They even disagree about what you should call it. Warren Buffet talks about "intrinsic", accountants, economists and central bankers say "Fair Value". Which is all very well but that opens another can of worms about how the word "fair" should be translated into Russian and Arabic.
In 2011 as Brent climbed from around $80 all the way up to $110, the Saudi's pronounced that they had decided to become the Fairy-Godmother-of-Last-Resort and keep pumping oil until the price came down to what they considered "Fair" - which at that time was $70 to $80. Their argument was that the world economy would suffer, if oil was more than $80. Not that they got any thanks for their public spiritedness. Ironically, the headlines these days talk of how the Saudi's and the rest of OPEC are deliberately pumping too much oil, so as to sabotage the valiant efforts by Freedom-Loving Americans to escape the ignominy of having to buy oil from what are less-than-diplomatically referred to as "aliens" on the signs in the arrivals lounge in Miami Airport.
Odd-ball (alien) valuation geeks (like me) go with the International Valuation Standards which talks about "Other than Market Value", but for the purpose of this article I'm going to stick with the word "fundamental" which at least communicates intuitively what I'm talking about.
So what is it...for oil?
According to me, the "fundamental" is as easy to calculate as working out where the sun will come up tomorrow, as is explained here: http://www.marketoracle.co.uk/Article24849.html
In summary, expressing the theory in nomenclature familiar to a trained economist:
For those of us who are not trained economists, the acronyms stand for:
FOOT Fundamental value Of Oil Today ($ per barrel of Brent)
TOAD Total Of All De World Gee-DEE-Pee ($Trillion per year - current prices)
OIK World-wide OIL Konsumption (Trillions of barrels per year)
What that says (according to the theory), is the amount of money that gets spent buying oil world-wide is a pretty constant function of GDP. If oil prices go up, consumption, relatively, goes down. Equally if consumption goes down (that usually happens when it's hard to get your hands on oil), prices go up. Evidence that theory might be correct is that it exactly explains the bust after the bubble in the 1980's and the one in 2009. Let's see if it works for the bust of 2014 or whenever $70 is breached!!?
On re-consideration, I've decided that the best constant in the algorithm looks more like 3.7% rather than 3.3%. Also it's worth remarking that's a world-wide figure, in China and USA which generate half the economic value added per barrel of oil they use, compared for example with Europe, the number is higher.
Plotting that out:
- The prediction only starts when oil goes down below $70; at that point there will be a bust in progress, all that the price of $85 says today is that might be coming about.
- If that doesn't happen now, all it means is the time the price will end up below the fundamental (FOOT) will be further out.
- There is no way to tell if the bust will happen now, just when it does, as it inevitably must (according to the theory), the fall-out will be of an order of four years.
- The implicit assumption is that by now, there is sufficient capacity to pump enough oil, and of course that there isn't a war or any other reason for supply to be constrained.
- And sure - in five years time, electric cars may indeed become a reality, that would affect the constant in the algorithm.