Beginning of the Correction?

It’s no big secret that I think oil prices ran ahead of themselves in the past couple of months. I don’t think they should have cracked $90 this year (and despite mass amnesia by analysts, as of August 99% were in that camp as well). But today, WTI traded into the $80’s for the first time in over a month. Of course prices may reverse before the close today (especially since it sounds like the Fed may cut interest rates again), or they may reverse next week. But I have a feeling that this is the beginning of the correction I have been expecting (and mentioned in this week’s TWIP).

It’s not that I don’t think oil is inherently worth $100/bbl. My objection to the price had more to do with how fast the price changed. Oil ran up by over 30% in just a couple of months, and this does not allow enough time to establish the new supply/demand balance. Did the fundamentals change that much in just a couple of months? No. Yet every piece of bullish news drove prices up, and bearish news did not drive it down. But lately I have been warning that traders would be wise to heed the signs that supply was increasing and demand was falling.

In spite of this, I was treated to an unending stream of rationalizations for why $100 was going to be a brief stop on the way to $150. Never mind that rising prices should be expected to moderate demand. Never mind that we hadn’t had enough time to establish the effect that $95 oil would have on demand. No, oil was going straight to the moon. I was told multiple times that speculators are not actually a factor – that the price was near $100 because of the fundamentals.

Speculators who were “in the money” suddenly became very clever, and I got treated to several lectures on how supply and demand worked – and why that favored $100 oil. I was told that “inventories were plunging”, even though it was quite easy to confirm that they were at normal levels (having fallen from ultra-high levels). And these are the very same people who confidently told me earlier in the year that Saudi was completely tapped out – even though I was predicting they would raise production later in the year.

But the tinfoil hat crowd is out in full force today. Because oil prices are down, I have seen suggestions that 1). The public is suffering from mass delusions; 2). Oil companies are manipulating the price; and 3). The government is manipulating the price. After all, “Peak Oil is here. How could oil prices fall? It must be manipulation and conspiracy.” Or, maybe Peak Oil is not here. That just doesn’t seem to enter the equation; that the supply/demand dynamics are changing. No, if you already know the answer – Peak Oil is here – then oil prices behaving contrary to that must have some other explanation.

The big stories over the next couple of weeks will be the OPEC meeting on December 5th, in which members are expected to announce another production boost, and the Fed meeting on December 11th, where another interest rate cut is forecast. Those meetings should set the direction of oil prices for the rest of 2007.

I think Saudi is going to have a tough time getting consensus on the production boost they reportedly desire, especially with oil prices already falling away from $100. There will probably be a compromise; perhaps a token production boost. Anything more substantial – 500,000 or more barrels per day – will probably put oil back in the lower $80’s. On the other hand, with oil prices down, the Fed may be more emboldened about making a bigger interest rate cut. Lately, each cut has been met with a falling dollar and rising oil prices. They may feel like they have a little more room to work with than they would have when oil was near $100.

December is going to be an interesting month.

27 thoughts on “Beginning of the Correction?”

  1. LOL! The wikipedia page explains the difference between effective and ineffective models!

    BTW, since we are sharing, and relating (tenuously, oh so tenuously) to the topic of … risk assessment.

    (After night of staying up late to coordinate with Russian programmers, that thing just cracked me up.)

  2. That little spasm towards $100 may be our all-time peak for a generation.
    Demand is flat, seem to go into decline. How can crude oil rise if demand falls?
    I concede I have no model in hand, but I suspect anything above $65 starts a reaction that ultimately leads to declines in oil demand.
    The problem with oil is that much of it resides in Thug States. That is the problem, and it will not go away. Even so, I think we have topped out.
    A couple interesting posts over at The Energy Blog today. One, on a method to improve extraction of heavy oil, and another on improved batteries.
    Never bet against the ingenuity of man in free and well-capitalized societies.
    We may even come to a better world, thanks to this energy scare. It is possible we end up with a cleaner and more prosperous world. The PHEV is a remarkable, transformative technology.
    Even those boobs in DC may not be able to foil this result.

  3. yes indeed, the correction is well underway…good thing i bought all those $90 puts 🙂

    however, the long term bull trend in oil is very much intact and supported by fundamentals, imo. and $100/br will be a reality eventually and i actually think w/i the next 5 yrs oil has no ceiling. which makes shorting oil the most precarious thing you can possibly do to your portfolio. if one really thinks demand has topped out for a generation, if you really really believe that and have the analysis and data to back that up then, you ought to be going to town on shorting oil futures.

  4. Robert is right, speculators looked for any excuse or bad news to drive prices up, but ignored good news.

    Hurricanes forecast above normal – price goes up. Fewer hurricanes – price still goes up. Inventories rise, prices go up, invenotries fall, prices go up. Hurricane Forecast Ignites Prices

    Iran snatches 15 British sailors, price goes up, the releases them, price goes up.

  5. Well, believe it or not, demand is up in far off places like CHINA. Right? No one around me has stopped driving. Demand hasn’t been reduced overall, has it? You’d have to have a TIN HAT to believe that.

    So demand goes up and oil production? We don’t know yet. All we have are WORDS. Just a few words from the Saudis. Doesn’t mean much of anything.

    You’ll see. And remember next time the Saudis promise something, it doesn’t mean anything until we look back at the numbers.

    If demand continues to rise, as it has been rather relentlessly, and supply stays roughly flat, the price goes up–unless of course the whole economy tanks on a global scale!

  6. however, the long term bull trend in oil is very much intact and supported by fundamentals, imo. and $100/br

    I find it hard to take you seriously when you don’t even know the abbreviation for units of crude oil – it is bbl. The history of it came from the “blue barrel”, the color Standard Oil used to paint the 42 gallon oil barrel to distinguish it from beer barrels or a dry barrel. The abbreviation for rates is bpd or BPD for “barrels per day”.

    This is the problem. People buying and selling energy futures without a clue about the industry.

  7. Ben,
    I am with you on the ingenuity of man. Ditto for the Boobs in DC.

    But I think you are confusing US demand (lots of data on that) with world-wide demand (the important one). The last numbers I saw showed oil being used at record levels. Demand growth may be slowing, but demand is not in decline.

    I also think the supply-demand equilibrium oil price depends much on the health of the world economy. It seems that the current world economy copes pretty well with $100/bbl (or slightly less) oil. Granted, the sub-prime mess could change all that.

    The best case scenario as I see it is that the world economy remains healthy and that oil keeps on its steady path to $150 and beyond. We need PHEV and other innovations to keep it from hitting $200 too quickly. Thug states will eventually collapse, high oil prices may just postpone that event by a few years…

  8. Entire world has vital stake in China’s energy challenge
    By Mikkal E. Herberg
    Article Launched: 11/27/2007 01:38:34 AM PST
    http://www.mercurynews.com/opinion/ci_7568750

    A major new report just released by the International Energy Agency (IEA) sheds stark light on one of the reasons why global oil prices are approaching an unprecedented $100 a barrel. The report provides truly stunning new details of the looming global impact of China and India on future energy markets and the prospects for climate change. It also brings a sobering clarity to the enormity of the energy challenge these two countries face and the huge stake the world has in their future energy choices.

    The IEA’s most striking conclusions concern China and the sheer scale of its unprecedented energy demand. For example, from 2001 to 2006 China added to global energy demand the equivalent of the entire 2006 energy consumption of Japan, the world’s third-largest energy consumer. Looked at another way, China added the equivalent demand of five countries the size of Spain or Mexico. In the IEA’s benchmark “Reference Scenario,” which assumes a modest 6 percent long-term economic growth rate, China accounts for one-third of global energy demand growth, for one-third of world oil demand growth, nearly two-thirds of world coal demand growth, 40 percent of world nuclear energy development, and one-third of world hydroelectric power development.

    Some of the most striking impacts will be in oil markets. China’s oil demand is likely to rise by 10 million barrels per day (MMBD) between 2005 and 2030, equal to Saudi Arabia’s total oil production capacity today.

    [snip]

  9. whoa! did i step on someone’s toes? lol. i guess you disagree w/ me or something…

    in my younger days, comments like that often ended up with me challenging the other to a duel :

  10. My problem with the rise in oil is in the traders thinking that consumers dont have ways out of the heavy oil appetite of the past decade. Forget the stuff that will be here in 2-3 years that will allow consumers to curtain almost all transportation related oil consumption (plug in hybrids for example), but its going to be EASY to gain a lot of surplus capacity when people get out of their very inefficient vehicles into much higher MPG vehicles. I hear all the time from analysts on TV that they think the consumers won’t give that stuff up. Of course they will! Faced with $3 and $4 a gallon gas, and 40+ mile work commutes for many of us, many are going to try to recover that lost income any way they can. I am in the upper middle class, as are many of my friends. We are considering getting fuel efficient cars, which should mean efficiency is even more essential for people of lesser means at current oil levels. I am convined the motor pool efficiency of the U.S. is going to improve very significantly in the next 5 years, with noticeable improvements in the next 2 years. I just dont hear this being talked about enough…

  11. ryan,

    i agree w/ almost everything in your post…almost…

    1. i am skeptical that w/i 3 yrs hybrids and plug in electrical cars will be the car most commuters drive.

    2. i think gas prices need to be $6-8/gal before we see real change in peoples’ driving habits.

    3. every dollar that you save from gasoline, either because you got a honda hybrid or because you’re telecommuting, goes right back into another form of consumption. Therefore, your energy consumption turns out more or less to be the same.

    yea, we are gonna see huge improvements in energy efficiency. but we soak up everything we save in some other form of consumption such as huge econ growth or just spend it somewhere else.

    dang it, we just need more oil flow! have a nice weekend, all!

  12. Well maybe not you personally. But the point is that there is a lot of stupid money trading oil and petroleum products. Most of it doesn’t have a clue about the underlying business.

    A couple of points on energy demand. The world oil market is about 80-85 mmBPD (that’s million, more funny oil company abbreviations). Of that the US is about 25%. So higher fuel economy and conservation in the US can make a big difference.

    China’s use is linked more directly to its economy. Much of the demand in China and India is for power generation. Oil fired power is the highest cost on the margin for both countries. But as long as the economies are cranking on exports, they make more money operating their factories. China subsidizes oil and gasoline through its national oil company. Both countries are converting to cheaper coal and natural gas. In addition, when the Three Gorges damn in 2009 will put a lot of hydro power on the margin, displacing oil. Also China has pegged and undervalued its currency relative to the US $. China has based its economy on cheap exports.

    Yes, the Chinese and Indians are prospering and purchasing automobiles, but where will they drive? Or better yet, where will they park? They aren’t likely to tear out their mass transit systems and suburbanize like the US. The Chinese know they are vulnerable to crude oil prices and supplies. So they are taking steps to reduce their dependency.

    As oil prices rise, alternatives emerge. Right now gas is about 1/2 the cost of oil. Coal is about 1/10th. If prices stay at the current levels more people will switch, and oil will be relegated to transportation only.

  13. So, demand is falling, which is not surprising at the price oil was selling for. Here in Japan the last spurt is just today (Dec. 1) being reflected in the prices of petroleum products with another 5 yen/liter price hike. Surely, that is spurring greater efforts at efficiency as people trade in their passenger cars for K-cars and seek more efficient appliances.

    But I doubt all of this decrease in demand can be attributed to better efficiency. How much of this decrease is the consequence of demand destruction forced on people of limited means? Surely many people who have lost their jobs and/or homes are using a lot less energy then they need/want. In other words, what percent results from a combination of economic woes and high price?

    I’m not preaching socialism, but just trying to get at the quality, rather than the quantity, of demand destruction, and say that we can’t celebrate reduced demand without some reservations.

  14. benny,

    doh! that sucks….if i knew you earlier i wouldve advised heavily against shorting futures at any cost.

    if you want to bet against oil, buy the puts where losses are limited and can be managed and used for hedging.

    if you want to talk off-line: email cta@tungcapital.com

  15. I think talk of OPEC increasing output is wishful thinking, today we had a statement from Qatari minister that “it is not on the agenda”.

    With continuing dollar weakness, I can’t see much to derail this bull market.

    One thing I find notable is that the summer/winter cycle on oil has broken, with summer supply concerns extending into winter. We are now watching the thermometer to gauge the next spike.

  16. OPEC ministers have contradicted themselves all week. One day, Nigeria is saying it will be under discussion. The next day, Saudi says no. The day after, Iran says yes. Today, Qatar says no. I mean, this pattern has gone on all week.

    They will definitely discuss it. After all, that’s what they do when they get together. No way is it not on the agenda.

  17. CTA

    If I had any investable funds left, I would contact you. I made rather lopsided bets. I was selling puts and calls.
    Knowing what is right, and doing it, are two different things, like any alcoholic at a bar knows.
    I tell myself it may have been cheaper than going to Las Vegas a lot. Okay, a whole lot.
    The market is correcting now, and I think it is a long-term correction.
    Oil consumption is not roaring ahead, as some still believe. We may be seeing slight declines in global fossil oil consumption now, and this trend will continue for a long time. Look at fossil oil consumption stats from the 1980s.
    By the way, some pople say “India’ whne talking about fossil oil. India’s demand fell minutely in 2006, and rose 0.6 percent in 2006. They are planting millions of hectares of jatropha, an oil-bearing shrub. The national goal of India is to reduce fossil diesel consumption by 20 percent.
    China is a baddie, but even there, we may see moderation in demand in several years, due to alternative fuels and the price mechanism.
    However, being intellectually right, and right in the markets, is two different things. If you need a contrary indicator, you can always ask me for advice.

  18. If you look at what OPEC ministers say, there is a lot of spin applied, depending on how the question is asked. The usual question is “will you be discussing an output rise?”, the ministers say sure “why not?”. If the question was “do you think the markets are well supplied and the price is inflated by speculation?” you get a different answer.

    A lot of reports say “the market (or traders) expect that..”, it’s not really based on what ministers are saying, but what markets are hoping for. That’s why I call it wishful thinking.

    In reality the question is will OPEC allow Saudi Arabia to increase output, since no one else can.

    The possibility of output increase is about the only thing holding price down, if that does not transpire then any little events will push the price higher.

  19. In an 80-85 million barrel a day market, not all crude use is for transportation, although that accounts for the bulk of it.

    The longer that crude stays at $90 per barrel and US gas at $7.50/mmBtu (the equivalent of $45 crude) there will be incentives for switching. Residents in the Northeast who are paying $1,200 to fill up their fuel oil tank may relook at the $2,500-3,000 to switch to natural gas.

    Don’t forget the price collapse of the late 1990s happened because about 2 million barrels of excess capacity came on the market as a result of the Asian currency crisis. We could see a collapse in crude prices quickly.

    If the US approved a lease sale in the 1002 (ANWR), along with an oil import fee to establish a floor price at $50-60/bbl we could see worldwide prices collapse toward the marginal cost of production (which isn’t $90).

  20. cta,

    I think you might be missing the point. The problem with our country is energy diversification. It is going to be cheaper to charge our cars with energy made from nuclear or coal power than with oil. Those commodities will see an increase with converts to plug in hybrids, but the price will be much less (and secure) than with a singular source of energy (oil). I disagree that it will take 6-8/gallon gas. People in the lower half are having a hard time with 3, let alone 4 or 5.

    Ryan

  21. every dollar that you save from gasoline, either because you got a honda hybrid or because you’re telecommuting, goes right back into another form of consumption. Therefore, your energy consumption turns out more or less to be the same.

    cta — You are getting close there to “Jevons’ Law”: conservation increases total demand for that resource instead of reducing it. Jevons wrote about this around the 1860s in his book “The Coal Question”. Politicians have ignored it ever since.

    Jevons was concerned about British ‘peak coal’ (as we would call it today), and investigated whether the life of Britain’s finite coal reserves could be extended by using coal more efficiently. Answer — No! For the reasons you outlined.

    Even though conservation is a Good Thing (and therefore has been practised by people since the days of the cave man), meeting human energy needs is a supply-side issue; can’t be handled on the demand-side alone — not humanely, at least.

    (By the way — Jevons was right, British coal production did reach a peak and decline. However, the consequent migration of British industry to other countries which still had coal did not happen, contrary to Jevons’ fears. Instead, the cost of shipping coal to Britain declined — new shipping technology — and other fuel sources emerged — oil. Never underestimate the power of human creativity!)

  22. Speaking of alternative energy sources: Scientists at Lawrence Berkeley National Laboratory have figured out a new technique for prospecting for geothermal energy. It involves examining helium isotope ratios. It’s not going to do us much good in getting off of oil (less that 2% of our electricity is generated from petroleum), but it might help China and India reduce their demand.

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