Oil prices currently have overshot to the downside as long term pricing and current supply/demand dynamics are both suggestive of a logical bottom in the US $30 - $35 range.
The primary purpose of a historical price chart of a financial asset is to tell its viewer the past and present of where it's been.
But wait, there is a secondary purpose. Financial analysts trained in the art of technical analysis also look at some price charts and allow their imagination, or more increasingly their computing power, to play around with the patterns suggested by them.
These may be suggestive of a trend, mean reversion or something more complex. These patterns can then be interpreted intuitively by means of a fairly standard system of technical charting lexiconography to forecast the future price.
In this way, a parallel of sorts may be drawn between tea leaves and price charts. The comparison becomes more pertinent at this time of the year when financial experts spend much energy attempting to foretell the future of stock markets, interest rates, commodities and currencies in their year ahead outlook reports.
Price per barrel of crude oil (WTI) from 1948 adjusted for inflation
Source: Nikko Asset Management
The inflation adjustment helps in reducing the distortions caused in price comparisons caused by the changing purchasing power of the currency in which it is denominated. A logarithmic scale makes it easier to compare a gain or fall in the series over different time periods.
The likely trajectory of oil prices could influence several key outcomes this year such as the path of inflation, monetary policy response of global central banks, the value of the US dollar and other currencies, capital expenditure plans of US energy companies. More broadly, it could influence earnings growth prospects of US corporates, the health of the US high yield bond market and its knock-on impacts on broader credit markets.
The market price of oil itself is driven by such a large number of economic and macro-political factors that forecasting it is no small task. The range of expert forecasts on oil prices for next year varies from lows in the $20's to as high as $60 per barrel implying the prospect for oil prices to fall further from their current levels or rise by a huge degree.
We believe the right question to ask might be: ‘where is the likely bottom in oil prices?’ This is because significant further declines are likely to have a greater impact on broader financial markets than gains.
To give the conclusion upfront: the bottom in oil prices should be in the $30 –$35 range, so we believe oil prices have overshot on the downside.
Mean reversion is an investment intuition that both fundamental and technical analysts agree to. The average price, shown as the red line on the chart, is the all too famous number of $42.
However, a key requirement for using mean reversion as a forecasting method is that the time series must appear to historically revert to some average value.
There seems no centre of gravity to which oil prices converge to with any regularity. Over the last sixty years oil prices have either spiked (in the 70s, late 90s, early noughties) or collapsed (80's, GFC, last couple of years) with such violence that the centre of gravity appears to constantly shift.
However, a deeper dive into the history of oil prices reveals that the largest swings were caused by an identifiable exogenous factor such as Middle East oil shock in 70s, the oil glut of the 80s, the China growth miracle of the 90s, and more recently the Chinese slowdown.
Excluding all such periods leaves us with the decade post the 80s oil glut and before the China induced take-off in the second half of the 90s. To the extent that current declines in oil prices have much to do with deflating expectations around Chinese growth it seems intuitive to use the average oil price just prior to that growth spurt as a reference.
Over 1986 – 1997, oil prices did indeed seem to mean revert around an average of $34. Factoring in some amount of overshoot hence suggests that a $30 – $35 bottom in oil prices is a reasonable expectation for the near term.
The Validation
It's pleasing to note that the $30 –$35 range stacks up reasonably well against a more educated, fundamentally driven outlook of oil prices.
Oil demand/supply models indicate the continuation of an oversupply situation caused by sluggish demand growth and increasing supply. The politics of OPEC suggest a lack of production discipline will keep supply high even as additional new supply from Iran comes onto global markets. Financial break-even costs on the other hand suggest a supply response is more than likely from US shale and other high marginal cost suppliers globally.
Over the past 10 years, the commodity super cycle and era of an effective OPEC market ‘balancing’ encouraged entrepreneurs to drill deeper, bigger and pricier wells. Ultra deepwater projects were sanctioned with breakeven costs over $90/bbl, while new sources of oil previously deemd to be uneconomical were developed such as US shale and Canadian oil sands.
Oil producers also ventured into jurisdictions with higher sovereign risk than was previously thought acceptable.
Oil, unlike most other commodities, has a concept called “natural decline”. Unlike a factory producing the same number of widgets year in year out, an oil field left alone will produce less and less with each passing year. According to the International Energy Agency, the average decline is 6.2 percent a year.
US shale has an even higher decline rate, estimated at an annual 47 per cent for the Bakken, 55 per cent for the Eagle Ford and 22 per cent for the Permian.
These shale plays accounted for a significant proportion of 2015’s US production. How do oil producers stop decline? They drill more wells and this requires capital.
Performance of oil over 2yrs
Source: FE Analytics
The halving of the oil price in 2014 took nearly all producers by surprise. In 2015, the attitude of most producers was a ‘wait and see’ approach.
Of course, they cut headcount, emphasised the most productive wells, squeezed suppliers and changed project scopes, but at the back of their minds they were waiting to see if this was a temporary blip or a longer term sustained drop.
The easy fruit was picked and most producers on average cut costs by 20 per cent. Now was 20 per cent good enough? Probably not - oil prices fell a further 30 per cent in 2015 and into early 2016 they fell a further 20 per cent.
As we move through 2016, most producers will find it a lot easier to say “no” in a US$35/bbl environment than at US$100/bbl and hence we would expect to see the natural wonder of decline occur to help bring the market back into balance.
The steep contango in the forward term structure of oil currently suggests ours is not such a non-consensus call.
While spot WTI has conclusively broken below $28 currently, forward prices of March 2017 oil contracts are still trading above $35. Given expectations around market rebalancing in the second half of the year this might seem reasonable.
An answer is still needed, though, regarding why the spot market is still in free fall. We believe this is just because by nature, commodities almost always overshoot.
The overshoot may have just become more pronounced this time because of the prolonged period of over-investment caused by artificially low interest rates, elevated geopolitical uncertainty caused by the end of Opec-era monopoly pricing, the potential re-entry of Iranian oil into global markets and the need of US shale operators to keep operating cash flows high enough to evade bankruptcy.
Be that as it may, the overshoot will also accelerate the eventual mean reversion as excess capacity is burned off.
Tanuj Dutt is a portfolio manager at Nikko Asset Management. The views expressed above are his own and should not be taken as investment advice.