Early this week the front month WTI contract traded as low as -$US45 due to a combination of short-term trading factors and long-term issues in global energy. The reason for the near-term price action is easily understood; global oil storage capacity is full so there is nowhere for excess oil to go and, therefore, every extra barrel of oil is worthless.   

How we arrived at extremely low oil prices is more complex.  Notonly is a reduction in global demand to blame but the combination of policy errors by Saudi Arabia and Russia and the inability of US energy companies to reduce production.   When Russia and Saudi Arabia couldn’t agree on production cuts in March the cascade of rapid oil price decline began.  US producers, who had increased production over the past few years and have significant debt to service couldn’t cut production.  Soon the world was awash in oil and, despite a global agreement to cut production by May 1st, prices have continued to fall. 

All that is now the past.  What the chart below (courtesy of the Wall Street Journal blog The Daily Shot) shows is that traders are betting that oil will be trading at closer to $US35 in the next year or so.  That’s up from today’s $US13 spot WTI price.  In fact, curiously, as the spot price of oil plummeted over the last few weeks traders have become more convinced that the long term price of oil will be significantly higher. 

The rationale for this view would be that, from a Saudi perspective with very low production costs, creating both price volatility and low prices makes funding US oil production impossible. The Saudis have surely achieved this goal as US energy drilling and production is already significantly reduced.  The argument for higher prices is that in 12 months there will be less oil around as global economies are back in full swing.   

Why might we want to be cautious around aoil price rebound within 12 months

First, it is a consensus investor view that a rebound will occur quickly, which should generally give us pause.  Second, in order for oil prices to rise dramatically we need a combination of continued reduced supply and increased demand outstripping the available stored oil and continued supply.  There are limits to how much oil production will be cut even with low prices so if economic growth is slow the glut of oil might remain for longer.  If prices do rise the question for investors is whether those prices will be high enough for long enough to generate sufficient returns on invested capital 

Inevitably the best cure for low prices is low prices, so eventually a combination of lack of new investment and production discipline will lead to higher prices but that may not be for quite some time.   

by  Gavin Ezekowitz