Oil Traders' Invisible Hand
Bank analysts are predicting the oil rally of recent weeks isn't going to last. It's important, though, to reflect on why the rally happened in the first place. It was never about supply and demand as such, but about the market's perception of where they were going. If oil prices head south again, that, too, will be a result of guesswork. Traders should know there is an element of self-fulfilling prophecy -- for the long term, as well as the short term -- in their pronouncements about today's oil market.
Crude oil prices started falling last September. Brent oil crashed by almost 55 percent by mid-January, but it's up about 32 percent since:
Yet nothing in particular happened in these five weeks to cause this upturn. There have been no bigger than average supply disruptions in the Middle East, no oil embargo against Russia, no reduction in U.S. shale output as a result of Saudi Arabia's price war. In fact, in the week that ended on February 6, the U.S. produced 9.226 million barrels of crude per day -- the most since the U.S. Energy Information Administration started taking weekly measurements in 1983.
To be sure, the rally was driven by data. There were announcements from large energy companies about falling profits, job cuts (IHS Global predicts up to 40,000 of these industry-wide unless prices rebound) and investment reductions. Then there was the falling U.S. rig count, provided by oil services company Baker Hughes -- a scary chart for any data-loving investor:
Together, the news suggested an impending Saudi victory over the U.S. shale industry that would force the latter to reduce output and thus end the global oil glut. Hence the rise in prices.
Now, a narrative pushback is beginning. Investors are learning that rig counts have diminishing value as an indicator. The rigs being idled are the least efficient vertical ones, while the more productive horizontal ones are increasing their share. A Bloomberg Intelligence report published yesterday talked of "more efficient rig deployment and unique well completion designs" underpinning the U.S. shale industry's surprising resilience.
Meanwhile, there are new numbers to obsess over: the U.S. has record output and developed nations have growing crude stocks. Here's another chart calling for knee-jerk action -- U.S. commercial crude inventories have reached a record level of 417.9 million barrels:
The frantic search for useful indicators isn't just a myopic trading strategy. It's also affecting long term trends. The current crude price level makes some of the provisionally scrapped investment projects look attractive again, but if speculators drive it down because they decide to watch oil stocks rather than drill counts, the projects will look bad by the time the next corporate investment committee meeting comes around.
Everything takes a long time in the oil industry. Investment cuts begin affecting production years after they are made. The Organization of Petroleum Exporting Countries pointed out in its February report that one of the reasons the falling rig count is not yet affecting output is that there's at least a three-month time lag between drilling and well completion. Unlike finance, oil extraction is done with heavy equipment and in constant combat with the forces of nature.
In the oil market, by contrast, nothing takes a long time. It's a financial market in which the only things that really matter are the dance of digits on a computer screen and the quick minds of people watching them.
People involved in the oil business often resent that. OPEC has long complained about the speculative nature of today's markets. In a recent Financial Times opinion piece, Igor Sechin, chief executive of Russia's state-owned oil major, Rosneft, wrote that "In today’s distorted oil markets prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst." He suggested that financial regulators make sure at least 10 or 15 percent of all oil trades actually involve supplies of that pungent black liquid rather than "electronic tokens or pieces of paper."
Regulatory wheels, however, turn just as slowly as industrial ones do, and there is no particular reason why governments in the West would want to interfere with the oil market now that low prices are about to benefit most of the developed world -- and hurt the likes of Russia and Venezuela. That leaves even the best-informed oilmen quarreling about price forecasts.
Sechin wrote in his article that if low prices keep depressing investment, "eventually" the price will climb to $90 to $110 per barrel. By contrast, Mikhail Fridman, a Russian billionaire who, two years ago, sold his oil assets to Rosneft, suggested in his own Financial Times commentary that low oil prices were the new reality -- and used much the same arguments to back that up as Sechin employed in justifying his $110 prediction. What determines the price, Fridman wrote, is "mere perception". Of course, that logic can work in either direction.
Perceptions are created, to a large extent, by media. I have been careful not to give preference to any perception in this column so far, though I do believe that countries such as Saudi Arabia and Russia have a higher tolerance for prolonged periods of cheap oil than do energy firms such as the U.S. shale operators and service companies. That gives them a built-in advantage in the price war that started last year, and another speculative panic leading to $30 or even $20 oil is not going to erode it. On the other hand, the market for sustainable energy has even more staying power than these countries do. In the long term, major technological trends and national interests are going to determine supply and demand on the oil market.
But the price of oil is another matter. That's going to depend on the headlines that reflect those national interests and technological advances -- or perhaps some new short term factors of the day. Traders rarely lack explanations for the numbers that skip across their screens.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
To contact the author on this story:
Leonid Bershidsky at email@example.com
To contact the editor on this story:
Cameron Abadi at firstname.lastname@example.org