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Should $20 A Barrel Be The Real Price Of Oil?

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Summary

Since the low in January of 2016, oil prices have rebounded to a recent price around $54.

Investor bullishness was driven by the belief in peak oil theory, the slow transition to electric and hybrid engines, and the use of the commodity oil as an investment in the China boom.

What does history say about the price of oil and its long-term trends?

Fool me once, shame on you. Fool me twice, shame on me!

In September of 2010, we argued that oil prices were trading on psychology and entrenched beliefs, and could possibly have a real price of $10 per barrel. Investor bullishness was driven by the belief in peak oil theory, the slow transition to electric and hybrid engines, and the use of the commodity oil as an investment in the China boom. We were early, but after topping out at $115 per barrel, WTI crude oil dropped like a lead balloon to as low as $29.42.

Since the low in January of 2016, oil prices have rebounded to a recent price around $54. What is Smead Capital Management’s position on oil prices and investments in oil-related securities? What does history say about the price of oil and its long-term trends? Do non-economic oil market participants tell you what you need to know about the future of oil prices?

Long History

As you can see from the following chart – in which the price per barrel has been adjusted to reflect the USD in 2014 terms – oil has a storied history of boom and bust cycles. Oil peaked during the Civil War due to supply shortages and then was pummeled off and on for 27 years by new oil discoveries. A spike in 1894 for a supply disruption in Azerbaijan and the rapid adoption of the automobile by 1929 kept the prices up to $40. These episodes came between long stretches where prices went back and forth around $20 per barrel. In effect, oil was in a bear market off and on until 1972.

Oil peaked in 1981 around $110 per barrel and bottomed at $20 in 1999. In the spring of 2011, oil nearly exceeded the all-time high price near $120 per barrel. Therefore, we believe this bounce to $54 per barrel is very much a dead-cat bounce or bear market rally from a historical standpoint.

Source

Non-Economic Investors

The chart below compares the volatility of oil prices with the volume of long oil contracts held by hedge funds on the commodity futures exchanges. It shows that hedge funds were optimistic in 2014 when oil was near $115 and again in early 2015. In the last few months, their enthusiasm has exploded to record highs on the move to $54 per barrel. This is a classic example of a crowded trade, where you start with almost no one believing in higher prices and you end up with almost everyone believing.

Source: Bloomberg

When a market has been abused by declining prices as much as oil did from 2014’s high to January 2016’s low, it usually takes years to regain a high level of enthusiasm. Think of how negative the experts were on U.S. stocks from 2009 to as recently as right before the 2016 November election. Think of how notorious those who were negative about the U.S. became during that era. This “wall of worry” has carried stock prices from 676 to around 2,363 on the S&P 500 Index as we write this missive in February of 2017.

These charts don’t guarantee anything; nor do they give any short-run clues about where oil prices are going. They do seem to argue that this is a bear market rally and that history tends to drive prices to around $20 per barrel in 2014 dollar terms. The oil business is cyclical and not that far away from a boom which caused Canadian tar sands and American fracking companies to create unusual wealth in a short period of time.

Lastly, when oil prices did hit a temporary low in early 2016, private equity companies were anxious to provide capital to the over-leveraged oil producers. These zombie companies have been kept alive and maintain hope of getting back to $80 per barrel. If that happens, we’d tip our caps to them. However, we think it is more likely that oil is currently peaking around $54 per barrel, and that oil investments will be available to contrarians like us at lower oil prices and at much better terms.

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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57 Comments on "Should $20 A Barrel Be The Real Price Of Oil?"

  1. rockman on Wed, 1st Mar 2017 9:09 am 

    The oil futures is its own universe. The price PHYSICAL oil is dominated by what refineries are willing to pay. And their model is dominated by their expectations of price modulated product demand. A product demand that’s dominated by motor fuels.

    The refineries and physical oil producers have a very small footprint in the futures market. It’s essentially dominated by gamblers who base their bets on the dynamics of the supplier/consumer relationship. And that PERCEIVED dynamic includes: “Investor bullishness was driven by the belief in peak oil theory, the slow transition to electric and hybrid engines, and the use of the commodity oil as an investment in the China boom” as well as other prejudices that can often be driven by emotions more the facts.

    And none of that PERCEIVED dynamic is used by the price setting refinery industry. The ExxonMobil refineries are not going to pay more for oil that won’t generate a profit by selling its products. Products sales prices that will be based on consumer demand.

  2. Nony on Wed, 1st Mar 2017 10:11 am 

    Price for the physical and for futures are closely correlated. (Within the price of transport and storage, duh!) When the futures prompt jumps $10, the physical will jump something close to that amount. Maybe a buck or two more/less.

    End product prices are closely correlated as well. You can see how gasoline jumps when crude jumps or drops when crude drops. Refineries are so used to this that they often just think in terms of “crack spread”. How much money they can charge for products minus what it costs to buy crude. Usually it is better for the refiners when crude price is low, because that incentivizes more driving (and refineries are a fixed cost business with slow addition of new capacity). But big picture, demand is relatively inelastic. So their main concerns are throughput and cost control. Mostly the former, since it is such a fixed asset business.

    Source: Done that, been there

  3. Rockman on Wed, 1st Mar 2017 11:23 am 

    “Price for the physical and for futures are closely correlated. ” Yes they are: the price of physical oil, set by the refineries, determine who makes and loses money in the futures market. The price trends in the price of physical oil is the basis speculators use the make their bets on future oil prices. IOW the price refineries set for their oil purchases determine where the futures market is heading….not the other way around .

    And speaking of what price oil “should be”: depends on what one is hoping for: short term lower prices that lead to long term shortages and much higher prices as the lower oil price does not encourage reserve replacement.

    And it looks like the Bakken is presenting a very good example of the dynamic. Saying the Bakken is “dead” is a tad overly dramatic but the numbers do seem prophetic of predictions of a year or two ago:

    http://oilpro.com/post/30230/beginning-end-bakken-shale-play?utm_source=DailyNewsletter&utm_medium=email&utm_campaign=newsletter&utm_term=2017-03-01&utm_content=Feature_1_txt

  4. twocats on Wed, 1st Mar 2017 11:47 am 

    When I was buying diesel at 4,000 gallons a pop, we would receive daily quotes from local fuel companies that would adjust their prices very closely to crude price jumps. And they were buying directly from refineries. Some days the price wouldn’t even last a full day if prices were going crazy like they were in 2008.

    I don’t know if these were “futures” pricing. It was whatever was on Yahoo Finance when you search for “crude”. /sarc. this whole line from rockman that the prices we see on financial websites or discussed here have no influence on what consumers pay is not true. It’s NOT it’s own universe. It was my universe for years and I worked in concrete construction operations. Not really a wall street high flyer.

  5. BobInget on Wed, 1st Mar 2017 12:00 pm 

    Swiped from ‘Investor web page’

    Some facts about shale drilling

    1) Unlike what EOG said, the shale wells recover 90% of the EUR in the first 5 years. I noticed this yesterday and Brookpe has acknowledged this in the comment section of Enno Peters article.

    2) Production decreases by 1.8 MM barrels/day/year if no wells are drilled.

    3) To maintain production, I am in Leopold’s camp that you have to drill for about 250000 barrels/day/month as the new wells lose 70% of production in one year.

    4) No analyst that I follow know any of the above facts. Unencumbered, they just churn out article about shale growth.

    5) The breakeven cost using average number for EUR and $10 MM/well are as follows. ND $40/barrel using 250K EUR, Permian $50/barrel using 200K EUR and Eagle Ford $60/barrel using 166 K EUR. The average well in US produces 200K and hence breakeven price is $50/barrel.

    6) The oil is discounted by about $10 for Bakken compared to WTI and I do not know the discount for other regions.

    Given all these factors, the shale growth is at best very much challenged unless oil price starts to increase.

  6. Nony on Wed, 1st Mar 2017 12:01 pm 

    Not sure why you bring Berman into a discussion of the linkage of spot and futures prices.

    That said, the article is one of Berman’s poorer ones. Shaleprofile.com shows clearly that wells in the Bakken are not getting worse. The opposite. Berman is just wrong.

  7. BobInget on Wed, 1st Mar 2017 12:10 pm 

    Venezuela in US Crosshairs..
    (note reference to ‘terrorists’

    According to the country’s recently released 2016 financial report, about $7.7 billion of its remaining $10.5 billion of reserves is in gold. To make debt payments in the past year, Venezuela shipped gold to Switzerland.
    The thinning reserves paint a scary financial picture as the country faces a humanitarian crisis sparked by an economic meltdown. Venezuelans are suffering massive food and medical shortages, as well as skyrocketing grocery prices.

    Related: Venezuela may have issued passports to people with ties to terrorism.

    Massive government overspending, a crashing currency, mismanagement of the country’s infrastructure and corruption are all factors that have sparked extremely high inflation in Venezuela. Inflation is expected to rise 1,660% this year and 2,880% in 2018, according to the IMF.
    Another key problem is the relatively low price of oil, which stands at half of what it was in 2014. Venezuela has more oil reserves than any other nation in the world, and oil shipments make up over 90% of the country’s total exports.
    That’s making it nearly impossible for the country to pay its debts and import food, medicine and other essentials for its citizens.
    Venezuela’s imports are down 50% from a year ago, according to Ecoanalitica, a research firm in Venezuela.
    CNNMoney (New York)
    First published March 1, 2017: 12:09 PM ET

    Here’s another tid-bit.
    Venezuela’s credit with China and Russia may well be
    compromised. Venezuela continues to export almost its entire export potential to the US instead of China as
    prearranged in China’s most recent $2 billion loan.

  8. twocats on Wed, 1st Mar 2017 1:38 pm 

    ” Oil peaked during the Civil War due to supply shortages and then was pummeled off and on for 27 years by new oil discoveries.”

    oh yeah, and how have those discoveries been going lately?

  9. rockman on Wed, 1st Mar 2017 3:10 pm 

    Twocats – “When I was buying diesel at 4,000 gallons a pop, we would receive daily quotes from local fuel companies that would adjust their prices very closely to crude price jumps.” No, they weren’t because they had no idea what oil was selling for that day. The price moves they were looking at were in the futures market. You were buying products from retailers. I sell oil to oil buyers who sell to refineries. The price I’ll get for my oil has no relationship to what future prices are this month. My contract does have a partial component of futures prices. But not those prices this month or even last month. That price factors in closing future 2 to 3 months past depending on which long term sales contract I’m looking at.

    Not sure about your supplier. It may have buying out of the spot market. Those trades are obviously directly related to the futures market since it is directly linked.

    The refinery that produced the diesel you bought in December bought the oil it came from in Oct or Dec. And paid a price that was affected to just a partial degree by what oil futures probably closed at during Aug or Sept.

    IOW the volatility of the diesel price you dealt with had nothing to do with the price refineries paid for the source oil.

    In fact the price volatility you were dealing with may have had nothing to do with physical oil prices and everything to do with the DIESEL FUTURES MARKET. You did know it existed, right? And that market is directly affected by the WTI futures market:

    http://marketrealist.com/2016/12/us-diesel-futures-follow-crude-oil-prices/

    Notice it’s not a direct comparison: the price difference between WTI futures and diesel futures late in the day on 11 Dec was $0.90/gal. And just 4 days later on 15 Dec is dropped to $0.30/gal. So yes: if your diesel supplier was buying wholesale from the spot market (or had a long term purchase contract tied to spot prices) his quotes to you could swing wildly from hour to hour. And that would have nothing to do with what oil producers were getting paid for the oil they sold that December.

    Which also explains why the retail sales prices of refinery products this month hold no interest to the Rockman because they have no impact on what he gets paid for his oil this month.

  10. rockman on Wed, 1st Mar 2017 3:34 pm 

    “Not sure why you bring Berman into a discussion of the linkage of spot and futures prices.” The discussion is about the long term effect of a lower oil price…such as $20/bbl. And towards that end the important take away from Art’s report is that:

    “Over the past two years, output {from the Bakken} has fallen 285,000 b/d (23%).”

    An EIA number.

    And that was at oil prices significantly above $20/bbl. As far as the newer wells being better produces: that hasn’t stopped the declining slope of Bakken production, has it? And how much oil the Bakken is producing is the critical metric…not how much new wells come on at since those better rates rates aren’t stopping the declining rate from the play.

    So I’ll toss out the same old worn out line: the solution to low oil prices is low oil prices. Especially at $20/bbl. LOL.

  11. Nony on Wed, 1st Mar 2017 3:44 pm 

    The price of spot and futures are closely correlated. Both prices will react to events. And are forward looking. IOW, if there will be a future addition or subtraction of demand or supply and market knows it, the prices will adjust for it, with a small difference based on transport and storage costs. This is oil trading 101.

    Retail prices will also react quickly to the price of crude. Even if the gasoline was made a month earlier, when crude was at a wildly different price, the retail price for the product will still adjust based on the new price of crude. Because it is also forward looking. The most recent example is the large rapid price plunge of crude in 2008. This is fuel marketing 101.

    The Berman story is STILL unrelated to the correlation of prompt and spot (which in fact ARE closely related). And his story does not pertain to $20 oil, since the average price last year was in the 40s. And his article is, even for him, a bad one. E.g. he makes false assertions about worse wells by generation in the Bakken, which are easily disproved by public information (and even by peak oil adherents and shale critics). But if your point is that people produce less oil when the price is lower, well, duh. And that still doesn’t relate to the correlation of spot and prompt.

    How about getting Rockdoc out here? I like him more.

  12. twocats on Wed, 1st Mar 2017 7:39 pm 

    Rockman – i agree with most of your rebuttal. it definitely isn’t a one-to-one relationship up and down the chain of purchasers, futures, etc. and i was very downstream, like you said, on the spot market. but just trying to say they may be different parts of a universe but there are some connections. either way, the article is absurd it seems from any angle in the universe. oil ain’t going down to $20 for very long ever again. thanks for your contributions.

  13. Boat on Wed, 1st Mar 2017 7:40 pm 

    If you pay attention to the drilling productivity reports the individual well average has been steadily going up the last 3 years. The first year and final totals are up dramatically. Canada has also seen the same types of production. The answers seem to come from increased sand, water and perforations. The learning curve continues.

  14. Boat on Wed, 1st Mar 2017 7:52 pm 

    Two cats,

    Let’s say Lybia and Nigeria found peace. They could easily add 1.5 to the market in a relativily short amount of time. If OPEC/Russia decided to retake market share you could end with close to a 3 Mbpd glut forcing prices back down. Never say never.

  15. GregT on Wed, 1st Mar 2017 8:52 pm 

    Boatard,

    The Oil Glut™ has been going on for a year and a half, yet prices are still close to twice what they were prior to the run up leading to the financial crisis of ’08.

    Why do you think that would be?

  16. Nony on Wed, 1st Mar 2017 8:54 pm 

    Librulz who think that wilderness is worth a damn. Holding back America.

    https://www.youtube.com/watch?v=4bHZRSlhJxY

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