Baron Rothschild - I cannot remember precisely which but one of the earlier members of the venerable banking dynasty - liked to tell investors something extremely simple but highly pertinent. "What goes up will eventually go down and what goes down will eventually go up," he repeated over and over again to explain why at the end of the day investing was to a large degree all about timing. In other words you buy or sell whenever you think the market is about to turn one way or other. If you want to be a bit safer, you sell a little early and you start buying again a little late in the cycle even if that implies trimming your ultimate profits. Nothing could be truer of the oil markets and oil prices. For all the sophistication and technology of 21st century oil trading and markets, large commodity firms and banks, oil companies and savvy financial investors still manage to get it wrong when it comes to forecasting the direction of oil prices. The last couple of years is a perfect example. In July 2014, the price of West Texas Intermediate (WTI) crude was roughly $105 a barrel while North Sea Brent was even higher. Industry and financial analysts led by Goldman Sachs, the influential US investment bank with a significant commodities trading business of its own, were suggesting that oil could reach $150 a barrel and even go up as far as $200 a barrel. Since then, prices have been falling in almost uninterrupted fashion with WTI crude hitting a low of about $26 a barrel in February this year. This was actually even lower than the lowest price oil hit during the 2008-2009 financial crisis and recession.
Analysts' doubts and market rules
And the usual suspects, led by Goldman Sachs, were forecasting only 3 months ago that the price of US crude would keep falling to $20 a barrel, possibly even lower. Since then, oil prices have rallied by nearly 80% with Brent trading in May at one stage close to $50 a barrel and WTI around $48 a barrel. In January, when Goldman Sachs and others were cautiously forecasting a continued drop in prices, the hedge fund community took the opposite view. Between the start of January and the end of April, hedge funds and other money managers almost tripled their net long position in WTI and Brent futures and options from 234 million barrels to a record 663 million barrels. Yet in the last few weeks, the hedge funds started reducing their long positions in crude as they turned more cautious just as Goldman Sachs became more bullish with its analysts suggesting in a research note that "the oil market has gone from nearing storage saturation to being in deficit much earlier than we expected." They went on to say that "the physical rebalancing of the oil market has finally started." This coincided with International Energy Agency report that forecast the global oil market "heading towards balance" after surprisingly strong demand in the first quarter of this year. The agency also projected that oversupply would be at 1.3 million b/d through the first half of this year as demand had been stronger than expected from China, India and Russia. The oversupply in the global oil market would steadily shrink during the next 2 years with demand again exceeding supply from 2018 onwards.
Is the glass half empty or half full?
The industry and analysts currently seem split . There are those who believe the oil cycle has finally reached the bottom and prices are destined to move higher to and above the $50 a barrel level by the end of the second quarter and then closer to $60 next year. Then there are those that believe the recent rally is a temporary phenomenon and that prices will deteriorate again. There are good arguments for both camps. The bullish side can point to the improvement in emerging market growth and demand prospects as well as stronger than expected US GDP performance. Geopolitics and other factors could also provoke supply cuts, which has been the case of late in Nigeria, Venezuela, Canada, Kuwait, northern Iraq and China, that would in turn support the price of oil. This camp does not believe Saudi Arabia would suddenly swamp the market with additional oil because of this would require additional costs and drilling rigs and in any case increasing capacity takes time. This is equally true of US shale producers who would not be able to simply turn on the taps overnight as some have suggested. Delays and cancellations of long term projects and investments by oil companies also imply that supply could be insufficient in the face of stronger demand. The Norwegian Rystad Energy Group estimates that to date a total of $270 billion of projects globally have been either deferred or cancelled. Equally the bears have some strong arguments. They point out that global growth may be lower than anticipated. The International Monetary Fund only recently reduced its global growth forecast to a mere 3.2% this year. The energy markets are also changing as a result of the eventual impact of various climate change policies. So while the IEA is forecasting the market returning to balance in the short term, in the longer term it sees demand dropping as a result of climate change and evolving emissions policies. Under one scenario, the IEA sees demand dropping by 22% by 2040 to 74 million b/d by that year if measures are put in place to keep global warming at necessary levels to avoid the worst consequences to the planet. Then, much more immediately, there is the position of Saudi Arabia which has such significant spare oil capacity that it could keep a lid on oil prices whatever time it may take to bring this extra capacity to ground. Last but not least, the value of the US dollar could still influence the short to medium term direction of the price of oil.
No base, no roof
During the first quarter of this year, dollar weakness was another factor that helped sustain oil prices. But the US Federal Reserve is now signaling quite clearly to the markets that it intends to go forward with another or possible two new interest rate rises this year. The dollar has thus been strengthening again weighing on the price of oil. At the end of the day, as one US oil industry observer put it, knowing what to believe and when to believe has always been a big part of figuring out the oil game, and never more so than today. One thing for sure is that volatility in oil prices has increased and will continue in an industry long used to significant ups and downs. Patrick Pouyanne, the chief executive of the French oil major Total, was quite candid about this a few weeks ago during a visit to Scotland to inaugurate a new £800 million gas processing plant in the Shetlands. “The price of oil is never stable,” he said. "We made a mistake in the industry when we were at $100/b. We thought it is a sort of floor. Today people think there is a ceiling. There is no floor, no ceiling; it will move up and down." Sounds familiar? The French oil chief seemed to be echoing in his own way what the wise old Baron Rothschild used to tell his rich clients.