The dirty little secret in the money game is that nobody can forecast consistently with any precision. And that's especially the case when there are supply and demand dynamics at play.
Oil has always been a volatile commodity and in recent years has become more volatile, as both the supply and demand curves have become more inelastic. That means small moves in either supply or demand can result in big price moves.
To recap, West Texas intermediate crude prices hit the high $140s (U.S.) a barrel in 2008 and recently dipped to the mid $20s this year. Prior to oil prices breaking clearly above $40 in 2004, oil prices had ranged from the mid to low teens to spikes to near $40 during Mideast conflicts and OPEC supply squeezes.
Recently, I went back and combed through OPECs annual reports for the past decade, a period marked by tremendous oil volatility. What my research showed was that back in 2010, OPEC had no idea that the fracking boom in the United States would have such a meaningful impact on world supplies.
Back in March, 2014, when prices were near $100, I presented the changing supply and demand characteristics of fracking on my weekly education segment on BNN Berman's Call. The futures market at the time had suggested longer-term prices were heading to the mid $70s.
After I presented that outlook, I got some not-so-nice e-mails from Western Canadian viewers that said I was nuts. World oil prices kept going up for several more months, but then investors realized that supply was a big issue. OPEC had always been able to nudge the supply picture back in balance, but they were beginning to lose control. Economic sanctions against Russia saw them turn the oil spigots up around the same time the United States went from 6 million barrels a day to over 9.7 million in the second quarter of 2015.
If the guys that control about one-third of the world's output do not have a clue on where supply and demand are going, who does?
The graph below shows the most recent quarterly International Energy Agency world supply and demand forecast. We can see that since the second quarter of 2014, supply has exceeded demand in a significant way. The global decline in supply has largely come from the weaker output in the United States, as rig counts come down. Most of the OPEC nations are producing at all-time high levels, except in places like Libya and Nigeria, where war-related disruptions have been significant in recent years and potential output could add almost 2 million barrels. Venezuela's failed economy, too, is running below potential, due to lack of investment in recent years. Russia is now the world's largest producer of crude oil and President Vladimir Putin is under severe financial stress. While they will most certainly be willing to jawbone prices higher, actually cutting production at the expense of market share is unlikely.
Fundamentally, OPEC countries need world prices at about $90 or more to balance their books. Recently, Saudi Arabia has borrowed billions to help funding shortfalls while their U.S. dollar exchange reserves have been falling rapidly. Many of these countries have relied on exploding revenues from energy prices for the past decade and are not well prepared for the lower-for-longer scenario. In the United States, the bulk of the new fracking business was financed with high-yield debt and they need to keep pumping out cash flow so they do not default. It's a very difficult supply scenario that probably does not fall much for now. As for depletion in reserves, the lack of current investment will matter in a few years, but not much for now.
The demand side is far more important to understand. The world is serious about reducing the carbon footprint. The best bet is that within 10 years every car made will have some degree of emission-free power and the biggest demand for world oil from trucking and driving will fall significantly. Technology improvements in battery and fuel cells is a game changer for the demand side.
Most analysts see supply and demand coming into balance some time in 2017, which they estimate should put the WTI price back toward $55-60. These same analysts six months ago thought the world would be in balance by now. The forecasts are all over the map. The futures markets have 2024 prices just below $60. So lower for longer is likely here for years. The OPEC announcement this week, which saw members reach a preliminary agreement to slash the group's output to between 32.5 million and 33 million barrels a day, from 33.2 million barrels a day in August, likely means little more than profits and losses for day traders.
The Canadian ETFs that invest in this sector – XEG (iShares S&P/TSX Capped Energy Index) and the ZEO (BMO S&P/TSX Equal Weight Oil and Gas) – are currently priced for West Texas intermediate in the mid to upper $50s. That's discounting far too much good news.
The strategic investor should accumulate when oil prices dip next to the $35-40 range in the coming months. Chasing this week's OPEC news is probably a losing strategy, save for the savviest of day traders out there.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.