Now that the oil price receives a lot of attention, I have asked Marshall Auerback of Pinetree Capital Ltd to what degree the oil price is driven by speculation. Here is his straight answer.
By Marshall Auerback and Lars Schall
Marshall Auerback, how much speculation is at work when it comes to the oil price?
Marshall Auerback: Personally, I think the fundamentals suggest something closer to $80. But I’m not oblivious to the geopolitical risks, which is why I am probably neutral on oil. My fundamental position is based on a lot of reading and research and here’s where I come to: Moves in the oil price correlate very well with the data on the position of speculators in the oil futures markets. Over a three-month time horizon commodities are all about speculation to the point of manipulation.
But over the longer term supply/demand fundamentals matter.
Marshall Auerback: The oil bulls contend that, despite a four-fold increase in the smoothed price of oil from the second half of the 1990s to the last five years, there will be very little in the way of an increase in the production of non-OPEC crude oil (and overall liquids).
Also, the oil bulls contend that, because of economic growth in an energy hungry emerging world, the demand for oil continues to grow at about 1.5% per annum, roughly the same rate as over a decade ago, despite the four-fold increase in oil’s real price.
As a result the oil bulls see very restrained production increases ahead. At current oil prices global demand increases will outstrip these production increases. Therefore over time the oil price must rise to ration demand down to the level of constrained supply.
Analysis of such supply/demand fundamentals is difficult and complex. I want to make two simple points that go against the position of the bulls.
First, the number of rigs drilling for oil in the U.S. is now almost 1100, and the technology has improved. You can see this already in the natural gas patch.
Between 2005 and 2009 the number of oil rigs in operation averaged 300. That proved to be enough to arrest 35 years of continuous decline in U.S. production of crude oil and engineer a small production increase.
If you take the additional number of rigs now in operation, their average time to drill a well, and their likely average production rate, you should get a huge increase in U.S. oil production, even after accounting for depletions in Alaska, the Gulf of Mexico, and the Lower 48.
Until recently, the DOE has reported only a 100,000 barrel a day increase in crude production.
In recent weeks they have been reporting an increase of about 330,000 barrels a day.
The current production increase may be larger and still rising, as I believe the DOE data is very lagged. It may reflect a much lower rig count from early this year. It is possible that the big production increase calculable from the much higher number of rigs drilling for oil is now underway.
In addition, there is a significant increase in U.S. production of other liquids as natural gas companies are drilling for wet gas rather than dry gas.
Though the U.S. is where all the shale oil development is occurring, the odds are that the four-fold increase in the oil price over the last decade and a half is resulting in some increase in non-OPEC production outside the U.S.
Non-OPEC production for this year and next year will probably significantly exceed the pessimistic estimates of the oil bulls.
As regards demand, the opportunity for demand destruction at today’s much higher prices lies with the substitution of oil in thermal applications in emerging economies. The potential for such demand destruction is ignored by the oil bulls, as is the recent slowdown in Asia.
The latest data on Chinese implied oil demand suggests that the big increase in Chinese oil consumption the bulls have been counting on may not be materializing in the face of much higher oil prices. Such demand destruction may now be occurring with a characteristic long lag. Look at their imports recently. Flat as the chest of an 11 year old Shanghail girl.
With Libya and Yemen slated to now come back on line and a significant increase in Iraq production as infrastructure bottlenecks are overcome, the odds are that the oil supply/demand fundamentals are getting worse relative to market expectations.
If spec positions in the oil derivatives markets are not driven higher by a further broad rise in all risk assets, the oil price should erode. By changing the chart, that erosion should cause spec liquidation and a deeper decline in the oil price. But as I stressed before, Iran might change all of that, so I’d be inclined to focus my shorts in the base metals/materials area.
Anyway, just my thoughts.
Thank you for them!
Marshall Auerback, born July 27, 1959 in Toronto, Canada, is familiar with the international scenery of finance firsthand. After graduating “magna cum laude” in English and Philosophy from Queen’s University in 1981 and receiving a law degree from Corpus Christi College, Oxford University, two years later, he was from 1983-1987 an investment manager at GT Management Ltd. in Hong-Kong.
From 1988-91, Mr. Auerback was based in Tokyo, where his Pacific Rim expertise was broadened to include the Japanese stock market. In 1992 he went to New York to ran an emerging markets hedge fund for the Tiedemann Investment Group until 1995. The next four years he worked as an international economics strategist for Veneroso Associates, which provided macroeconomic strategy to a number of leading institutional investors.
From 1999-2002, he managed the Prudent Global Fixed Income Fund for David W. Tice & Associates, a global investment management firm, and assisted with the management of the Prudent Bear Fund. Since 2003 he was serving as a global portfolio strategist for RAB Capital Plc, a UK-based fund management group. He was also co-manager of the RAB Gold Fund and an independent economic consultant for PIMCO, the world’s largest bond fund management group.
He is now the Director of and Corporate Spokesperson for Pinetree Capital Ltd, a Toronto-headquartered diversified investment, financial advisory and merchant banking firm focused on investing in early stage micro and small-cap resource companies. Pinetree, which has a market cap of $439 million, is invested primarily in Uranium and Coal, Oil & Gas, Precious Metals, Potash, Lithium and Rare Earths and Base Metals.
Moreover, he is a fellow of the Economists for Peace & Security (www.epsusa.org) and of the Japan Policy Research Institute in California (www.jpri.org). As Braintruster of the Franklin and Eleanor Roosevelt Institute, he is a frequent commentator at “New Deal 2.0” (www.newdeal20.org). At present, Mr. Auerback lives in Denver, U.S.A.