What's Next For Oil? Use Logic

All right. Now we've tried everything. And we still can't figure out when oil prices will finally turn around – or at least stabilize.

Experts' predictions are all over the map. Smart people – including analysts, industry executives, and entrepreneurs – are on both sides. Many predict even lower oil prices before the market steadies itself. Many others predict oil in the $40-60 range again as soon as the 2nd half of 2016. Both groups have applied rigorous study and analysis. Both have valid, compelling points.

Yet, the more I listen, the more confused I become. Meanwhile, oil prices continue falling like a knife. What's truly causing this massive, slow-moving train wreck from $107/barrel in June 2014 to $27/barrel 19 months later?

Logic

Recently, many pundits and experts seem to be speaking in a refreshing new language. It sounds a lot like logic and common sense. I've heard a ton of commentary lately that makes me go "hmm, that seems logical." Today I'll summarize a selection of these observations, and add a few musings of my own.

We've tried everything else. Let's try applying some logic to the situation.

OPEC logic

In the old days, before fracking launched this tremendous US shale boom, the Organization of Petroleum Exporting Countries (OPEC) cartel could largely control prices by varying its supply of oil to the world. This time around, though, OPEC hasn't cut production once throughout the entire painful ordeal.

The colorful Jim Cramer recently interviewed a man Cramer calls "the most knowledgeable person I talk to about the state of the global oil markets." Rusty Braziel is president and principal energy markets consultant for RBN Energy and author of The Domino Effect, a book about how the shale revolution has been transforming energy markets.

Follow Braziel's intuitive logic:

"Let's say the Saudis reduce their production. So, what's going to happen next? No doubt, prices would increase. But then what? Then US producers would jump back in there, drilling would ramp up, and US production would start growing again. And when that happens, prices drop right back down. So, the Saudis end up with less market share and low prices. Why would they do that? Of course, they wouldn't."

Makes sense when you think of it from the Saudi perspective, right? Tough situation for them. Actually, I'll go as far as to say US ingenuity, innovation, and entrepreneurship has done it again! Once a slave to foreign oil, we now have OPEC by the cajones!

Don Luskin, Chief Investment Officer at Trend Macrolytics, wrote in a recent Wall Street Journal opinion piece:

"Oil is abundant. It will be for decades, if not centuries because there is shale everywhere in the world."

Wow! Sounds like we've solved "Peak Oil." This calls to mind Saudi Prince Alwaleed's provocative statement way back on January 11, 2015 (over 1 year ago, when prices were around $50) that "we're never going to see $100 anymore."

Braziel also points out oil stayed pretty much in a $7 range (between $15 and $22) from 1986 -2000. That's a 14-year period, in which (like today) supply outstripped demand. For what it's worth, Braziel's prediction (which he prefers to call a "guess") is that the new range will be the $30s to the $50s or $60s, perhaps for many years.

I think we can all see now in hindsight that, as Braziel described, US producers indeed would have responded to any higher prices with immediate output growth. Of course, they would've (and yet still might)! Look what they've done even with crashing prices! US energy firms have continued producing, and have yet to default or even engage in merger and acquisitions in a large way – much to the befuddlement of many experts (although we're bound to see more restructurings, closings, and combinations at some point). Thus far, almost all producers are continuing to pursue their own profits and survival. Imagine if oil prices were still in the $40s or $50s! All the US firms that are holding out hope today at $27 would be pumping like mad, even more so than now.

Swing producer logic

Continuing in the same vein, OPEC's price-manipulation in the past earned them the commonly used moniker of "swing producer." When prices got too low, OPEC could easily cut production for a while without fear of losing market share, thereby causing prices to stabilize. OPEC practically controlled oil prices.

Allianz's Chief Economic Adviser and former Harvard endowment investment manager Mohammed El-Erian explained the new dynamic in a recent interview with Bloomberg (video), as follows:

"You no longer have an effective swing producer. You no longer have OPEC reducing output when prices go down, and that is a real fundamental change that the market has to absorb, and it's going to take time."

Indeed, we're seeing this play out before our very eyes. The market is absorbing a fundamental change, and it is going to take time.

Furthermore, not only is OPEC no longer a swing producer; no one is! Certainly the US shale oil producers are unlikely candidates for the title, at least not en masse or in a coordinated way. The industry is highly fragmented, and it’s not a cartel like OPEC. So yes, the lack of a swing producer is a fundamental change.

"Was oil mispriced?" logic

Okay, but how can oil go from $107 to $27? Was the commodity that "mispriced" back in June 2014?

I still struggle with that question, frankly. I suppose perhaps $107 was the right price for June 2014 (although possibly a little overinflated) and perhaps $27 is the right price for today (although possibly the crash has become overdone?).

Maybe $107 was a bit high. Prince Alwaleed thought so. Obviously, had we all known in advance what would happen next, no one would have paid $107.

Conversely, I don't know that $27 is the new "permanent" price for oil. I’m not making that call. As El-Erian said, the market is adjusting, and it's going to take time. With this kind of volatility, I wouldn't be surprised to see $15 and/or $45 in the next 30-60 days. The key word being "and/or."

"What's changed?" logic

Here's a question:

What do markets understand today that we didn't know when oil was $107/bbl., in June 2014?

On that date, we already knew China's economy was growing at a slower pace, thereby slowing demand growth. We also already knew, prior to June 2014, about the entire magnificent US shale revolution!

Until Thanksgiving 2014, though, we did NOT know OPEC would continue pumping – nay, would actually increase output – all the way to $27 per barrel (thus far)! So I do believe OPEC's behavior was a surprise factor.

Still, on Thanksgiving 2014, when OPEC announced it would not be reducing output, oil fell from $74 to $68. It had already fallen about 30% from its June 2014 highs of $107. And in the ensuing 2 months, crude fell another 34% – all the way to $45 – by January 28, 2015 (almost exactly 1 year ago).

Prices drifted higher – all the way to $60 – by June 2015. Since July 1, though, oil resumed its massive slide, dropping by over 50% again, from $60 to today's $27.

Surely the market understood – and priced in – the OPEC dynamic within the 3-4 month period before and after Thanksgiving 2014, right? Then why do we now sit at $27 instead of somewhere in the $40s or $50s, at least?

In my article next week, I'll consider at least 4 possible explanations:

• Supply
• Demand
• Sentiment
• Technical factors

Best,
Adam Feik
INO.com Contributor - Energies

Disclosure: At the time of post publication, this contributor owned Enterprise Product Partners (EDP), but did not own any other stock mentioned. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.