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Should $20 A Barrel Be The Real Price Of Oil?

Consumption

Summary

Since the low in January of 2016, oil prices have rebounded to a recent price around $54.

Investor bullishness was driven by the belief in peak oil theory, the slow transition to electric and hybrid engines, and the use of the commodity oil as an investment in the China boom.

What does history say about the price of oil and its long-term trends?

Fool me once, shame on you. Fool me twice, shame on me!

In September of 2010, we argued that oil prices were trading on psychology and entrenched beliefs, and could possibly have a real price of $10 per barrel. Investor bullishness was driven by the belief in peak oil theory, the slow transition to electric and hybrid engines, and the use of the commodity oil as an investment in the China boom. We were early, but after topping out at $115 per barrel, WTI crude oil dropped like a lead balloon to as low as $29.42.

Since the low in January of 2016, oil prices have rebounded to a recent price around $54. What is Smead Capital Management’s position on oil prices and investments in oil-related securities? What does history say about the price of oil and its long-term trends? Do non-economic oil market participants tell you what you need to know about the future of oil prices?

Long History

As you can see from the following chart – in which the price per barrel has been adjusted to reflect the USD in 2014 terms – oil has a storied history of boom and bust cycles. Oil peaked during the Civil War due to supply shortages and then was pummeled off and on for 27 years by new oil discoveries. A spike in 1894 for a supply disruption in Azerbaijan and the rapid adoption of the automobile by 1929 kept the prices up to $40. These episodes came between long stretches where prices went back and forth around $20 per barrel. In effect, oil was in a bear market off and on until 1972.

Oil peaked in 1981 around $110 per barrel and bottomed at $20 in 1999. In the spring of 2011, oil nearly exceeded the all-time high price near $120 per barrel. Therefore, we believe this bounce to $54 per barrel is very much a dead-cat bounce or bear market rally from a historical standpoint.

Source

Non-Economic Investors

The chart below compares the volatility of oil prices with the volume of long oil contracts held by hedge funds on the commodity futures exchanges. It shows that hedge funds were optimistic in 2014 when oil was near $115 and again in early 2015. In the last few months, their enthusiasm has exploded to record highs on the move to $54 per barrel. This is a classic example of a crowded trade, where you start with almost no one believing in higher prices and you end up with almost everyone believing.

Source: Bloomberg

When a market has been abused by declining prices as much as oil did from 2014’s high to January 2016’s low, it usually takes years to regain a high level of enthusiasm. Think of how negative the experts were on U.S. stocks from 2009 to as recently as right before the 2016 November election. Think of how notorious those who were negative about the U.S. became during that era. This “wall of worry” has carried stock prices from 676 to around 2,363 on the S&P 500 Index as we write this missive in February of 2017.

These charts don’t guarantee anything; nor do they give any short-run clues about where oil prices are going. They do seem to argue that this is a bear market rally and that history tends to drive prices to around $20 per barrel in 2014 dollar terms. The oil business is cyclical and not that far away from a boom which caused Canadian tar sands and American fracking companies to create unusual wealth in a short period of time.

Lastly, when oil prices did hit a temporary low in early 2016, private equity companies were anxious to provide capital to the over-leveraged oil producers. These zombie companies have been kept alive and maintain hope of getting back to $80 per barrel. If that happens, we’d tip our caps to them. However, we think it is more likely that oil is currently peaking around $54 per barrel, and that oil investments will be available to contrarians like us at lower oil prices and at much better terms.

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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  7. makati1 on Tue, 30th Apr 2019 4:34 am 

    Oil should never have been below $1,000/bbl. The energy embedded is worth much more and its many uses only adds to its value. But stupid, greedy humans have wasted it on crap for over 100 years and are now going to pay the real price, extinction. Be patient. Its coming!.

  8. Davy on Tue, 30th Apr 2019 6:01 am 

    Oil is nothing without an economy. Today and in the recent past oil made our modern economy but also it took a modern economy to make oil into what it is. This is the classic symbiotic relationship found in the web of life but also human economics. Labor, capital, and resources must be balanced over time for true value to be realized but in addition the investment must be truly productive and not malinvestment. If you invest in economics without a future then the real return is low.

    Unless you are a king who wants to declare oil a precious commodity expensive oil means nothing. Oil has been around for thousands of years but it was only a modern economy that made oil valuable. It is the relationship of the cost and volume of oil to the productive ability of an economy that yields real value. EROI of energy sources is the proper way of looking at this situation in the big picture. Too often EROI is confused by saying this or that resource is low or high. The confusion comes in because of the way humans use a resource matters too. A low EROI resource can have a higher return if used properly.

    The better way to say oil value is too low is to say our modern human economy is wasteful. We have too many people and our consumptive value is low. To realize economies of scale we consume too much. A significant amount of what we consume yields waste and is destructive. We have too much wasteful affluence and this affluence is not sustainable nor is it resilient. The globalized system of comparative advantage exploiting economies of scale with cheap capital and transport within an inefficient energy machine but it is very potent when it is operating. It can’t operate long because we have a finite arrangement with consumptive habits that represent planetary overshoot.

    Cheapish oil is a key to our current arrangement but also sophisticated tech and lots of people. Only some of these people are smart that run the energy machine of civilization and even less people are wise. Understanding its sustainability is not high on our list if it were we would be living differently. Smart people understand the sustainability issue but the wisdom is not there because smart people are also delusional when they think they can continue to have what they can’t have by employing a new technology. This is an energy trap or a classic predicament of behavior and resources. Limits are understood but not acted on properly.

    Oil could be used differently and have a very high value in an alternative human arrangement. In the current arrangement oil only has a limited value because of the way our global system must operate. Raise the price of oil and we have unproductive segments stop using expensive oil. This then creates a knock on effect of throttling down the velocity of economic activity that strangles the economy. Oil in our globalism has a range of value it can never break out of for very long or there is destructive consequences.

    This then points to an associated problem with energy and that is how we live and utilize energy. This is the behavioral aspect of energy that is often ignored by fake greens and industrialist alike. Until we change behavior we are never going to transition away from oil fully and oil will never attain its true value. Renewables will never be our future until fundamental changes occur to how we inhabit our world and the scale of our footprint. This appears to means different consumption from less people who are wiser.

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    Anyhow, I see you offer writing assistance for people that are so poor, yet would benefit from the help of qualified writers. I am so poor, I have to use bark and tree moss for butt-wipe. In my house, when someone asks where the bathroom is, I tell them “pick a corner… any corner.”. When I was a little A-hole, I asked mom what was for dinner, she’d put her foot on the table and said “corn”. Most of my income is used on keeping the internet on, as the world needs to hear my REAL GREEN message. Several times a day actually. To save money I cut and paste the words of others, but that is only because a lack of proper food and diet has rendered me incapable of much in way of original thought anymore, beyond swearing and insults. I can remember those just fine, but that is about the extent of it.

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