Editor’s note: In light of dramatic developments in oil pricing, we asked Jason Stevens of Sprott Global to sit with us and explain what is going on:
QUESTION: Oil prices have fallen at the same time as the US dollar has strengthened versus gold. Coincidence?
I suspect the strength of the US dollar starting in July 2014 initiated the selloff in oil prices. There has been a very clear inverse correlation between oil prices and the dollar for many years. The following chart shows the price action of the US Dollar Index and the Western Texas Intermediate oil prices leading up to the OPEC meeting in November 2014:
QUESTION: How do you weigh the following factors in explaining oil prices: supply (Saudi Arabian policy, fracking), dollar index strength v. a basket of other currencies, and anticipated world commercial activity?
The fact is that the global oil markets were over-supplied by about 3MMbls at $90/bbl prior to October 2014 due to both weak global demand and increased North American production.
The most common misconception about the increase of North American supply is that most people believe it was mostly technology-driven. While hydraulic fracturing, multi-stage fracturing, and horizontal drilling all contributed to better well-economics, domestic production soared because of two main factors: (1) high oil prices and (2) cheap credit. Since 2011, banks extended lines of credit that equated to multiples of energy companies’ cash flows because returns looked fantastic at $100/bbl. The number of economic projects that came online then produced more oil than was necessary to satisfy world consumption.
The decision by Saudi Arabia to sustain production at current levels in November 2014 accelerated the sell-off. I believe much of the subsequent collapse below $60/bbl has come at the hand of leveraged derivative speculation.
Prior to July 2014, the oil markets were dominated by the expectation of supply disruptions from Iraq, Iran, Libya, Nigeria and Saudi Arabia. Black swan events can still disrupt the Middle East supply but current markets are not pricing in those concerns.
QUESTION: How accurate are oil price forecasts made in the principal organs of the financial press?
In my experience, professional prognosticators (like Goldman Sachs, who gave some probability of a ‘Super-spike’ in oil to $200/bbl in 2008) are notoriously bad at predicting both short- and long-term prices. In fact, a 2008 study by two Michigan economists showed that expecting no change in oil price over the next quarter was 34% more accurate than the average of dozens of professional forecasters.
QUESTION: Do you have a 12-month forecast for oil prices?
Now that I’ve just insulted forecasters, I’ll give you my expectation for oil markets in the next 12 months… I expect oil prices to buoy from their lows in the second half of 2015 and rebound to $65-$70/bbl by January 2016.
Standing inventories of North American wells drilled in 2014 will continue to increase production and put pressure on prices in Q1 and Q2 of 2015. Over-optimistic drilling budgets will be slashed throughout the year and rig counts will fall drastically by June 2015. In the latter half of 2015, drilling for production growth will stop altogether and spending in areas with steep decline rates in unconventional production, like the Bakken, will see virtually no new activity.
QUESTION: Are commodities properly part of a diversified portfolio? The S&P 500 prices have increased 17.94% over past 5 years, while the Dow Jones – UBS Commodity Index has gone up by 1.5%.
Absolutely. There will be periods of strong global growth and higher-than-average inflation when an investor will want adequate exposure to commodity-related investments. Now is the time to be evaluating the fundamentals of companies involved in the most out-of-favor markets- precious metals, energy, uranium, and iron ore to name a few.
I regularly suggest 5-15% in gold (for financial catastrophe insurance) and another 5-15% in carefully-selected resource investments including energy, mining, agriculture, etc.
Jason Stevens is an Investment Executive at Sprott Global Resource Investments Ltd. (Member FINRA/SIPC)
Read “Food Scarcity Risk Creates Need for Investment” by Jason Stevens, here.