The oil market has been on a rollercoaster ride over the last few years.
Before summer 2014, prices looked as though they’d never drop below $100 a barrel again. By the end of last year, every analyst and his granny was saying that prices were heading for $20 a barrel and would never see $100 again.
Now, the “supply glut” appears to be less permanent than anyone had thought. And crude prices are back near $50.
We take a look at what’s going on below. But to cut a long story short, this looks like the start of a much more significant shift – one that could have implications for your entire investment portfolio, not just oil companies…
Why contrarian thinking works
I can’t claim any great prescience on the oil market. Before the most recent crash in summer 2014, I did marvel at the ability of the oil price to defy gravity amid growing volumes of US shale oil. But I’d almost given up on prices falling by the time they did.
However, the oil market does provide a wonderful illustration of how markets pull the rug out from under everyone at the point of maximum consensus. When the forecasts start to sound outlandish – when they start to extrapolate the current trend to very aggressive or even ridiculous levels – you know you should be watching for a turning point.
For example, Goldman Sachs called for $200 oil before the last big oil price crash in 2008. And just before the recent rally, it was calling for oil prices to hit $20 a barrel.
This isn’t a coincidence. This is the logic of contrarianism at work.
Markets don’t exist in a vacuum. When people expect markets to do one thing, this affects their behaviour, which in turn has an effect on the market. George Soros calls it “reflexivity”. It just means that it’s difficult to separate cause from effect, because there’s a circular process going on.
But it also means that contrarianism – looking for signs of consensus thinking and then betting against it – can work. And the oil market provides some very good examples.
If professional analysts become over-confident to the point where they are willing to make drastic public forecasts for the oil price to go to $200 a barrel, what are oil executives and their shareholders thinking? Almost certainly: “Pump more oil!”
So the producers of the commodity make more and more aggressive decisions on production, ignoring costs and embarking on grandiose projects, because they believe that the price will justify the effort. And of course, higher production leads to lower prices.
Prices change expectations (or perhaps “beliefs” is a better word), which change behaviour. Behaviour changes prices, which change expectations/beliefs. On and on it goes.
It’s the same on the way down. Prices fall. Analysts don’t get it at first. Prices fall harder. Analysts scramble to catch up. Before long, everyone’s looking at $20 oil. At that point, the oil company executives and shareholders are shutting down production left, right and centre, conducting mass lay-offs.
Everyone expects the glut to continue. So it’s very easy to be surprised in the other direction. Any signs of unexpected shutdowns lead to the price jumping.
And that’s what’s happening now.
Demand for oil is strong – supply is running into unexpected problems
“The global oil market has flipped into a deficit sooner than Goldman Sachs… had expected”, says Bloomberg.
Defying the world’s most reviled investment bank is a bold thing to do, you might think. But that’s the oil market for you.
Demand has remained intact and is set to grow this year. The International Energy Agency highlighted demand from India in particular last week.
Supply on the other hand, has been hard hit by unexpected factors such as wildfires in Canada’s tar sands state, Alberta, and attacks on pipelines in troubled Nigeria, which have sent output from the African nation down to a 20-year low. China’s oil production has also tumbled – it’s at its lowest in 14 months, reports Bloomberg – while imports are at near-record levels.
Production has slid by 1.5 million to two million barrels a day, meaning that even although inventories remain at record-high levels, they are starting to shrink. According to analysts from Barclays, the market looks set to see “rebalancing much faster than previously expected”.
Does this shift in sentiment mean the rally is likely to get choked off? Maybe. But there’s another sign that it could have further to go – oil explorers and producers are hedging heavily (in other words, they’re locking in today’s prices rather than risk losing money tomorrow), which suggests they remain sceptical, which in turn is likely to weigh on production prospects.
The big shift
What would a rising oil price mean? It’s good news for producers, obviously, and we had a look at how to profit from this in a recent issue of MoneyWeek magazine.
However, it’ll also have another interesting effect. The big deflation scare over the past year or so has been linked to concerns over collapsing Chinese demand and wobbly growth in other countries. That’s then been compounded by falling resource prices, which have weighed on headline inflation figures.
Yet if resources prices have collapsed because of over-supply rather than problems with demand – which is pretty clearly the case – then deflation fears are overdone, to say the least.
Getting back to the point about contrarianism mentioned above, we have a market that’s been positioned for one set of events – deflation and stagnation – for a long time. What if something else happens? What if, instead of secular stagnation and a new normal, we get something more benign – and more inflationary?
My colleague Charlie Morris has been writing a great deal on this in The Fleet Street Letter, and the investment implications are so profound that I asked him to write our cover story in MoneyWeek magazine this week to highlight what he considers to be the most important investment theme of this year. Look out for it – and if you’re not already a subscriber, get your first six issues for £6 here.