Courtesy of Joshua Brown, The Reformed Broker
Over the weekend I posted some thoughts from my friend Dan Dicker (Fast Money, Oil's Endless Bid) on what truly drives the oil markets these days. He and the guys from Hedgeye had gotten into a disagreement about it earlier and I gave Dan some space to say his peace.
The gist of Dan's view is that supply and demand have a lot less than most people would think when it comes to the price of a barrel of oil.
Anyway, Daryl Jones, Director of Research for Hedgeye Risk Management asked if he could respond to Dan here on TRB. What follows below is a point-by-point response to the five oil market misunderstandings as laid out by Dicker over the weekend. Let me just say that I've learned a lot from both of these gentlemen and that we, the readers, are benefiting greatly – the silver lining in this disagreement.
Here's Daryl (who has just bought Dan's book for himself, by the way):
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1. Oil prices are determined largely by supply and demand. They’re not.
Oil prices are, of course, determined by many factors. To ignore or completely downplay supply and demand is dangerous. On a very basic level, the current dynamics of global pricing validate the importance of considering supply and demand factors. Specifically, if physical supply and demand factors were irrelevant, then the spread between the price of Brent and West Texas Intermediate (WTI) would not be roughly $20 per barrel, driven by tighter supply for Brent due to infrastructure issues in North America.
Moreover, other commodities validate the idea that supply and demand continue to matter. While we have seen an increase in “financialized” oil, we have also seen this across the commodity complex. In particular, the U.S. natural gas market has seen a rampant increase in speculative activity over the past decade (think Amaranth as an anecdotal example), yet the natural gas market continues to respond to fundamental supply and demand signals, just as copper does, just as grains do, just as livestock does, and so forth.
Certainly, the “financialization” of commodity markets is an important factor in the price of commodities. According to a recent paper by the Federal Reserve Bank of St. Louis titled, “Speculation in the Oil Market” (Juvenal and Petrella), it has been “estimated that assets allocated to commodity index trading strategies rose from $13 billion in 2004 to $260 billion as of March 2008”. This paper concludes:
“Our results confirm that Kilian’s (2009) conclusion that global demand shocks as the main drivers of oil fluctuations remains robust. In addition, we show that speculative shocks are the second most important driver of oil prices.”
So, yes, speculation matters, but only in conjunction with, and even secondarily to, supply and demand fundamentals. We wouldn’t necessarily support all of the conclusions of the aforementioned paper, but there is valid and quantifiable evidence of the role of global demand. Even so, these are only two of a number of factors that drive energy prices.
2. Oil prices are inevitably headed upwards because we’re running out.
Our view isn’t that we are running out of oil, although there is clear evidence that oil is increasingly difficult and expensive to get out of the ground. There is also clear evidence to support the concept of peak oil on both a regional and basin level basis, as evidenced by the declines curves in both the North Sea and West Texas.
On a basic level, though, the fact that oil production growth over the last decade has not responded to rapidly ramping prices is perhaps the best evidence that oil does have supply constraints. Specifically, the price of WTI increased by roughly 132% from June 2000 to June 2010, but this run up in price barely budged global production which had an average annual growth of 1.2% in that period, according to British Petroleum’s statistical abstract. This compares to a 2.2% average growth rate for global production from June 1966 to June 2010 based on the same dataset.
The more critical point related to supply is that the net export market appears to be shrinking, so even as there remains ample supply to satisfy global demand, the market of oil available to be exported continues to shrink. We recently held a call with Jeffrey Brown, a Texas based geologist, who has done a great deal of work on the global net export market. According to his analysis, available net exports have declined 2.8% per year from 2005 – 2010. So, while the amount of available oil globally isn’t in decline, the size of the export market, or that oil which is actually available to be traded, is in decline. In effect, oil exporters are using more oil to satisfy internal demand.
More importantly, though, is the fact that most people actually don’t believe in Peak Oil. In contrast to Dicker’s point that, “this “Peak Oil” argument has only really served as a psychological driver of continued investment into oil by funds, institutions and individuals.” A recent survey at a Credit Suisse investor conference revealed that 94% of investors believe that peak oil is at least twenty years or more away or will never occur. To the extent we believe the Credit Suisse data, it is not supportive of Dicker’s thesis that institutional investors are piling into oil because they believe Peak Oil is imminent.
3 – Oil price inflation is entirely a function of the devaluation of the dollar.
Our process would never suggest that there is simply one factor that drives the price of oil, but the U.S. dollar is a critical factor in determing the price of oil globally. Over the long run, the correlation between the U.S. dollar and the price of oil is a strong one. As an example, between 2006 and 2009 the correlation of the CAD / USD was 0.80. Intuitively, this makes sense. The debauching of a currency in which a commodity, or asset, is priced naturally makes that commodity worth more of those debauched dollars. On some level, it is basic math.
4 – Oil companies are the prime beneficiaries of “financialized” oil and therefore higher prices.
We don’t have a strong view on whether oil companies are the prime beneficiaries of “financialized” oil and therefore higher oil prices. Admittedly, over the last decade, the oil majors have seen their stock prices struggle to keep up with the price of oil. In fact, for the decade ending June 2010, Exxon Mobil, the largest public energy company in that period, saw its stock price increase by 39% versus an almost 132% for the price of WTI. Interestingly, in calendar year 2011, Exxon Mobil’s oil production fell by 5% for the year, roughly in line with global aggregate decline rates, and supportive of the idea that oil is increasingly difficult to come by.
On the longer term duration, though, Exxon Mobil has dramatically outperformed oil’s appreciation. From June 30th, 1983 to June 30th, 2010, Exxon is up 1,252% and WTI is up 414%. So, while Dicker makes a definite statement that oil companies do not benefit from higher oil prices, this is dependent on many factors, specifically the time frame, size of company, and quality of assets.
5 – The “speculative” premium in oil is perhaps 8 to 10 dollars and due to geopolitical risks like Iran and the Arab Spring.
We have no doubt that there is a speculative premium in oil. Certainly, with Iran actively saber rattling towards Israel, threatening to close the Strait of Hormuz, and with the Arab Spring limiting current production in countries like Libya, geo-politics is an important factor. That said, we would caution on selecting an arbitrary dollar amount to represent that premium.
Moreover, in aggregate, Dicker believes that the “speculative premium in oil is at least forty dollars a barrel and perhaps more.” He may be more correct in his assessment, but round dollar price targets, unless they are based on math, can be very arbitrarily determined. If forty dollars, why not fifty, or why not thirty? We utilize multifactor, back tested models to determine future prices, which, even if not always spot on, give us a variety of price outcomes that back test with a high degree of significance. While price targets driven by math with messy critters like decimal points tend to be less superficially pleasing, they also tend to be more accurate.
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Thanks to both Dan and Daryl for allowing me to play host to this dialog. You guys play nice now, ok?
