For the last decade, any time crude oil dropped below $40 per barrel it was a sign that the global economy was in trouble. Crude dipped to $38 in August after China’s stock market crashed, but with the biggest spike in the CBOE Volatility Index (VIX) since the 2008 credit crisis, it may have been based more on fear than reality.
While many analysts say that crude oil prices are headed lower because of an increase in global production and weak global demand, the evidence suggests that may be changing. Global demand is exceeding expectations and the U.S. economy is gaining strength.
Capital spending cuts and project cuts will tighten supply. More than 20 billion barrels of future production have been shut. We expect to see rising demand and less supply. The International Energy Agency (IEA) says that we could see a contraction of 500,000 barrels a day of global production. Those numbers could become worse as the U.S. shale industry is under pressure, with waves of bankruptcies making it harder for companies to raise capital. A much bigger drop in U.S. output could be on the way as 16 shale companies have defaulted in 2015, with more on the bubble.
While many have been fearful about weakening demand, global demand is at a five-year high according to the IEA, and it is raising its demand growth outlook for 2016. The IEA says that rising global demand and lower output in North America and Venezuela should resolve the current crude glut.
History also tells us that when crude prices crash quickly, they always rebound. When prices fall they create more demand and usually we see that drop in production.
If China’s problems are worse than currently anticipated, crude oil could drop below $40 again; but short of that, $40 is a huge bottom of the range. The days of sub-$40 crude oil—absent a global economic crisis—are over. Long-term, expect crude to test the spring highs, that were interrupted only by three extraordinary geopolitical events: Greek default, Iranian nuclear deal and the Chinese stock market crash.
For more than a century and a half, the price of crude oil has been remarkably stable. Expressed in terms of today’s dollars, the average price has been about $34 per barrel, and it has generally traded in a range between $15 and $40. An economist looking at the long-term chart of oil prices would say that it is “mean-reverting.”
There have been four prolonged periods when oil traded well above its normal range: After the onset of the Civil War (when oil was used primarily as an illuminant and a lubricant), following the Arab oil embargo in 1973, the Iran hostage crisis in 1978 and the U.S. invasion of Iraq in 2003. That most recent spike was the worst and longest period of high oil prices in history—no wonder the “Great Recession” was so great, and no wonder the recovery from it has been so weak.
Since early May 2011, commodities of all kinds entered a bear market, but oil most of all. In today’s dollars, oil has fallen 63% since then, while the CRB commodity index has fallen only 29%—despite that world demand for commodities has fallen while demand for petroleum is at all-time highs.
How is this possible? The answer is horizontal drilling and hydraulic fracturing (fracking). This technology represents an industrial revolution no less transformative than the invention of the transistor and the integrated circuit.
Just as “Moore’s Law” has driven the lower prices, more miniaturization and higher capability of electronics, fracking will relentlessly drive down the price of oil and make it more plentiful globally as a world of latent shale resources are unlocked. During the mere half-decade in which operators have been fracking for crude oil, productivity has been growing exponentially, just as with semiconductors.
Armed with this technology, oil prices will revert to their historic norms between $15 and $40. But one could go further. Transistors are now essentially free; millions come embedded in every credit card. Give frackers a couple decades, and soon enough, oil will be free too.
The trading implications? Well, let’s just say the futures curve for crude is very, very wrong.