Oil — Where Is It Going? Up, Up And Away!

Last week, I posted about my belief that oil has currently dropped to a price level that is damaging to the long-term stability of the oil market, and that while it seems wonderful right now, it won’t last.

Today we find a bit of evidence that may only support this point:

The $25 low-end estimate [Francisco] Blanch recites is based upon a furthering destruction of Chinese and other emerging-market growth in 2009, and it is astounding if it turns out to be true.

We have witnessed the perfect storm of declining commodity pricing in the last six months — a tsunami of credit tightening, capital withdrawal on a massive scale, dollar strength, weakening emerging-market growth and finally a deflationary spiral that seems to never be ending.

The oil markets, if they represent perfect efficiency as the equity markets normally do, would indicate either that Francisco is very, very wrong with his oil predictions or that we are in for far deeper problems with the rest of our economy. Far-forward contracts of oil are trading at a premium to front months rarely seen before in my history of trading the stuff and in a way that looks unbelievable to other longtime participants.

As I write this piece, January crude is trading for delivery later this month at $43.40 a barrel. Amazingly, January crude for delivery in December of 2009 is trading at $57.50 a barrel, a premium of more than 32%. This premium (contango) nature of the markets has rarely been so great and would allow for a riskless trade. One could buy crude oil for delivery this month, store it and sell next January’s contract for delivery 12 months later. With margin, storage and financing costs, you’d still clear a healthy 11% profit.

Now, I’m a big fan of futures markets. However, futures markets don’t represent truth, they represent an aggregate of belief — and are often trustworthy because it’s belief backed up with money. As such, futures markets tend to be extremely accurate when correct. When wrong, though, they’re often spectacularly wrong, because when groupthink takes over, belief becomes decoupled with reason. This could be easily seen in the housing market, houses representing a similar case to a futures market (i.e. you buy and hold, betting the price in the long-term future will continue to rise, and then even more so recently with house “flippers” speculating on near-term future prices), where the belief that it will simply keep going up only enhances the height it reaches before the inevitable crash.

But I don’t think that is the case here. The pundits are all asking “how low will oil go.” The futures market says it’s headed up. If the futures traders were trading these contracts at $25/bbl, I’d call it groupthink, the belief that things are just going to spiral down worse out of control. But they’re not, they’re exercising a contrarian point with the $57/bbl price. When pundits and futures traders disagree, I know who I’m more likely to trust.

I think what we’re seeing here is a confluence of unintended consequences that many people only purport to understand. Extremely complex are markets making moves that appear contrary to “normal” behavior, and thus everything is becoming very unpredictable. Bailouts here, money-printing there, and debt deflation out of left field have all thrown markets out of whack. It’s going to take time to sort this out, but the oil futures traders are assuming that when it finally happens, we’re more likely to be at $57+/bbl than $25/bbl.

They [and I] may be wrong… When dealing with such complex systems, it’s hard to gauge all the inputs and outputs and every relationship between them. But when you take the prospective theories about what’s going on, I think the plausibility of demand destruction creating a 70% downward move in prices is in question. I think the belief that this is a strong dollar / credit crunch issue is a lot more plausible, and with all the money-printing going on worldwide, I don’t see how anyone can reasonably predict $25/bbl oil.

  • John Hodge

    Yes times are hard but the world will recover and when it does it will find that the low cost of oil today which has inhibited oil production investment today will be the cause of higher oil prices tomorrow. Oil is finite and as yet there is no proven convenient substitute for oil as a transport fuel. Demand will grow and unless there is investment there shall be future shortages.

  • Xerox

    Oil is down due to a dramatic drop in global economic activity. Not too hard to decipher. The only way it’s going to rocket or steadily climb again will be 1)monetary inflation or 2)global recovery.

  • http://www.thelibertypapers.org/author/tarran/ tarran

    Except that monetary inflation won’t help: the prices of inputs to the production process will rise too.

    Let’s face it. Most oil producers are good at
    a) analyzing future demand
    b) scheduling projects in order to synchronize production to demand.

    The notion that they won’t invest in future production out of a short sighted assumption that present demand = future demand is pretty inaccurate.

  • http://thelibertypapers.org/ Brad Warbiany


    The point of my post (more accurately, the linked post from last week) was that the drop in oil prices is more than simple supply and demand. That, coupled with this post about how distortion of pricing signals can completely screw up a market, and you get what I’m talking about.

    There are so many outside forces driving the price of oil down that it’s bigger than a simple drop in economic activity. But producers are behaving like they would if it were a normal slowdown. We will have severe monetary inflation, and that coupled with supply destruction will cause much higher future prices of oil.