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Page added on January 27, 2016

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What Oil Can Tell Us About The Future?

Consumption

Our civilization is growing and the pace of this growth is becoming faster every day. The population of Earth is over 7.3 bn and this enormous bunch of humans need a lot of power to drive the household appliances, cars and to light bigger and bigger cities. The 20th century has been ruled by one power source – OIL. Oil, together with gas and coal have met the energy demand in the past and they will in the future. However, the energy market has changed and it will be a subject of even more dynamic changes in the future. Firstly, a lot of people has become aware of the environment pollution and greenhouse effect, which are caused by the use of fossil fuels. Due to this fact, the beginning of the 21st century has passed under the name of renewable energy sources (wind, sun, water, biofuels, geothermal). They have been a subject of a huge government subsidies, especially in UE. Of course, these kind of sources are not so widespread as conventional ones. Although, the shift in thinking about the future of energy market has been made and renewables are going to have a major place in it.

It was a  future, now let’s take a look at the past. The chart below presents, how the price of future contract on a crude oil (CL.F) has been changing since 1940’s:

Oil

We can see a dynamic rise in 1940s, the oil crisis in 1970’s, a stable growth during the first decade of 21st century and a fall during the financial crisis on 2007. The oil price is a subject of many, strong political tensions. We have an OPEC cartel, which embargo caused the first oil crisis in 1973. The Iranian Revolution and a decrease of world oil supply by approximately 4% has invoked a widespread panic, which doubled the crude oil price in the next 12 months. The peak in 1990 was caused by the Iraqi invasion of Kuwait and US response to this. There are many factors of 2000s energy crises; experts usually lists: the Middle East tensions, soaring demand from China, the falling value of US dollar, decline in petroleum reserves and financial speculation. As you can see, the price of oil is a subject of huge political impact and reacts strongly to the changes in supply and demand.

Oil

In the past index and oil price were strongly correlated. When FTSE was going up, the oil price was going up too. Since 2013, we can see a huge divergence. The oil price is plummeting and the market is rising. This is caused by two factors:

  • US production of oil has doubled in the last several years. Canadian and Iraqi production/export are rising year after year. The bigger the supply, the lower the price. The inside disagreement in OPEC cartel, makes impossible to cut the oil production,
  • The demand for oil in Europe and developing countries is low, because their economics are weak. What’s more, due to the improvement of energy-efficiency (vehicles, household appliances) and a huge development of renewables in countries like e.g. Germany, the demand is falling. The correlation between energy consumption and the growth of GDP is weakening.

These processes have been a huge game changers for the world market.

We have tried to find a sync points, that can be the most useful for describing the current situation. After a few tries, we have decided, that the simple, one year change of the crude oil price can serve for this purpose. You can see it, on the chart below:

Oil

On the first glimpse, there is a lot of “noise” in the behavior of chosen indicator. However, the sync points selected by us, are clearly visible. We are talking about a situation, when the Crude Oil Future CH1Y crosses the zero level, after it has reached the bottom below the level of -40%. 

These sync points have been marked on the chart below:

Oil

The next step is to check, what was the FTSE250 behavior after these events. The chart below presents it, during one and a half-year after the appearance of the sync point:

Oil

We have here:

  • One extremely negative path (20%)
  • Four extremely positive paths (80%)

It is a very good result and there is an 80% probability, that after a bottom below -40% and the crossing of zero level, the index will end up higher, than it has been at the beginning. The median return is +22% in a one and a half-year, which gives us around +14% in a year. For the periods of the same length, the median for FTSE250 is 14% in a one and a half year, which is a 9% in a year. The sync points chosen in this manner, has produced about +5 p.p. better results, than the market’s median. This strategy gives an investing edge and is quite reliable.

However, one more observation need to be made. The first 6-7 months after the sync point, are a little bit irregular. After this time, we can see, that all 5 paths had got a growing tendency. In conclusion, it is better to wait a couple of months after the Crude Oil Future CH1y has crossed the zero level and then, to invest. It will give you a lot less fluctuation and more stable returns. The risk is lower and you can sleep better with your money putted on the market.

What will happen in 2016?

As we have said earlier, the oil price is heading down since 2013 and there is a probability, that the bottom, which fulfills our conditions has been created. We need to wait and see, if our indicator will exceed the zero level. If so, the sync point will appear and we can expect, that FTSE250 will end up higher in 1.5 year after that event. The awaited return is somewhere around +22% during this period.

valuewalk



9 Comments on "What Oil Can Tell Us About The Future?"

  1. makati1 on Wed, 27th Jan 2016 8:47 am 

    Guessing…

  2. Davy on Wed, 27th Jan 2016 9:29 am 

    I don’t think referring to history works very well in the new age of limits and decay. Normal price discovery is trumped by the moral hazard of easing and rate repression. Markets are controlled both by central banks and High value traders. Demand is being savaged by bubble deflation at multiple levels. The biggest bubble deflating is China.

    In the medium term we have the consequences of this demand destruction with physical oil production capacity. Beyond that we have a declining energy gradient to an oil dead state where oil can no longer power the economy enough to ensure real growth. This point could be as little as 6 years away.

    In the mean time economies are being destroyed. Confidence is eroding. Tensions are building with trade wars. The always present geo-political issues are heated. Climate change is now a present wild card ready to strike anywhere anytime. This is obviously not like daddy’s world was. To expect oil to behave like we think it might in this new environment is hubris.

  3. paulo1 on Wed, 27th Jan 2016 9:34 am 

    If the future rhymes as opposed to repeat, one still needs to be reciting the same verse. I think in this case, as our momentum slows, we have picked up and entirely new book. Furthermore, the author didn’t correlate debt to his/her prognosis.

    I have met people who read tea leaves or cast runes. I think I’ll stick with the ELM model and reports of URR, etc.

  4. twocats on Wed, 27th Jan 2016 9:34 am 

    Value investing has taken a beating in the past 6 years versus momentum investing, but hey, maybe now is the time.

    This particular value-idea around oil price vs ftse is idiotic, but there might be other value investing ideas worth taking a look at.

  5. Apneaman on Wed, 27th Jan 2016 10:01 am 

    “Our civilization is growing and the pace of this growth is becoming faster every day.”

    A very apt description of a terminal cancer approaching end stage.

  6. Lawfish1964 on Wed, 27th Jan 2016 10:09 am 

    I get the impression English is not this author’s first language.

  7. shortonoil on Wed, 27th Jan 2016 12:06 pm 

    Prices have declined by 70% with almost no subsequent increase in consumption. For the first time in history production increased, but the economy did not follow. The world has been extracting the best quality, lowest cost crude that could be found for the last 150 years. One would think that someone would start connecting the dots. If someone has, they sure are not writing about it!

    http://www.thehillsgroup.org/

  8. JuanP on Wed, 27th Jan 2016 12:47 pm 

    Failed states and states of failure. http://www.truthdig.com/report/item/failed_states_and_states_of_failure_20160125

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