the oil bubble

8/3/2019 The Oil Bubble

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Ever Wondered what made oil prices to peak to $140 a barrel and then what made it dipto as low as $35 a barrel? This First-Global article was published in September 2008. Itwas a time when oil prices were at its peak. The article was titled, Oil at $30-50 abarrel. Many would have laughed it off. But they were right on. This article proves itselfright and every bit of it. Must read to understand what causes a bubble and what causes

the bubble to burst.. read on.

Our Quant side flagged the move in crude oil prices on May 30, 2008. They were, asnearly always, right on the money. And now its time for the data crunchers like us to getinto action. It is our firm belief that crude oil represents a true bubble.1 The tests of a truebubble are that it should have little connection with fundamental data; that the bubblesvery existence should create ample nonsensical stories as to why the bubble is for real,and that it will last and last. Crude Oil meets the test quite handsomely.We spoke briefly about this in our recent tome:

Quote 2

Are we running out of oil? In the last couple of years, oil prices have skyrocketed to

new levels, thereby raising concerns for everyone who is anyone in the world of business

and trade and for everyone whos not, as well However, looking into the economics of oil and in view of the factors detailed later,

we believe crude oil prices will witness downward pressure sooner rather than later.

Theres nothing that has fundamentally changed in the demand-supply balance, severallarge discoveries have been made and the oil bubble will burst fairly soon


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Lets try making our casein a short, crisp manner.

As is clear, there is hardly any correlation between annual changes in demand and the priceof oil. If demand increases and the price of oil increases, then we all sit there and draw upspurious correlations between the two. Fact is, there is virtually no consistent finding onhigher consumption- leading-to-higher-prices theory.Second, and perhaps even more damning is this statistic on the long term demand andconsumption growth trends of crude oil.


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As is clear, the long term demand growth has been in a fairly tight cluster. Throughbooms and busts.

So what is so different now, one might ask? Nothing.

At least to our untrained mind, the crude oil saga of $10-145 has been nothing but a giantattempt by the intelligentsia to put logicany logicin order to justify this 15-fold risein the price of crude oil. Fact is, there is no logic.

The world pretty much continued consuming at the same/similar rate of growth last fiveyears, as it has for the previous twenty. Ok, ok27 basis points higher than the twentyyear CAGR! No, it was the supply, stupid: Thats what the other comeback punch fromthe Oil-at-$200 camp is: Thats where the problem lies. This is an even bigger load ofrubbish. The world is well supplied in oil. And it does not take genius to figure out thatno matter what, the world will definitely add to its reserves over the course of the nextten-twenty-thirty years. So here you are: The bull case for Oil rested on insatiable supply

from China and India, and dwindling reserves.

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Both are patently wrong. In fact, false.China and India, combined, simply cant make up for consumption slowdowns from therest of the world, especially the US, Eurozone and Japan. And there is plenty of anecdotalevidence to suggest that even the Chinese demand is exaggerated because China hasoverbought for the Olympics. The world has fairly comfortable reserves. And there isfrenetic discovery exploration on in Russia, Brazil, India, Iran and elsewhere. So, its afairly easy case to make that the world, indeed, will be awash in oil in a few years fromnow, relative to demand.

The truth is: Oil had been in pretty long bear market. Hadnt adjusted for inflation for along while. And the rally in Oil was nothing but a huge catch-up rally, to adjust for yearsof non-performance. These things happen in asset classes. We all know that.

One of the best examples of this is the Chinese stock market. China grew massively, asan economy, between 1995 and 2005. Logically, the Chinese stock market (or whateverpassed for it in those days), should have gone ballistic. It went nowhere. In fact, on a 10-year basic, the mainland China Shanghai Index was down. All this GDP growth, all thismassive investment in infrastructure, all amounted to nothing in terms of stock marketperformance. And then, in November-December 2005, China took off. And went up 5x injust two years or so. And predictably, came the stories: Chinas GDP growth; Chinasmassive consumption all things animate and inanimate; Chinas mobile subscribersChinas this and Chinas that: all of that will keep driving up the Chinese stock market.

As always, what was being done was to that logic was being fitted to suit the price. Allthe reasons for the boom in China had been existence for 10 years. But since the logicnever fit the price, it was never used. The moment prices ran up, the logic was dusted outand presented to the world. Fact was, as we had written in an earlier report, the Chinesebull market was nothing but the correction of a long term aberration of high growth andpoor stock market returns. The market ran up just enough to temporarily correct theaberrationand that having been achieved, has promptly and dutifully halved, and then


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some. Its the same with currencies. When the US Dollar goes down, people say tradedeficit. Never mind that the US has always runs a big trade deficit, and this hasntprevented the Dollar from going all over the placebeing a weak currency and a strongcurrency, alternatingly, for the past several decades. And now, when the Dollar hassuddenly strengthened, people are blaming it dovish statements from the ECB,

conveniently forgetting the trade deficit and interest rate differential!

The short point is: Currency and Commodity movements are largely technical in nature.They have no value. Only price. And price on its own, moves only on technical factors.Once the move happens, fundamental nonsense is drummed up to support the price.It is our case. Nay, stand: Crude Oil will tank (short term bear market ralliesnotwithstanding) to below $90 by this year-end, and by our reckoning, should hit $50 inthe next 12 months time. Thats not such a reach, actually because thats precisely whereit was in January 2007. And you never know: when a bubble bursts, theres no sayingwhere it stops collapsing. So, we for once, wouldnt be in the least surprised if crude goesall the way back to $30. As Chart 1 shows, this has happened many times in the past

100+ years. And will most certainly happen again.

And God help crude oil if the US Dollar continues strengthening, as we think it will, simplybecause consensus is far too strong on the Dollars demise.

Now, for the detailed storythe graphs, the charts, the data

Oil prices to follow declining oil demandWe continue to hear about rapidly rising oil demand being driven primarily by China, Indiaand other emerging countries. Nevertheless, let us take a look at some hard facts.


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The above Chart 2 is a typical commodity price-demand chart and is applicable to almost allcommodities, including crude oil, i.e. price moving up, demand tapering and vice versa.Towards 2007, the figure shows the price line and Y-o-Y demand line moving away, thoughthe demand grew 1.17% in 2007, which was a bit higher than the demand growth in 2006 (up1.1%). However, the average price in 2007 was also at $72 a barrel and the world economywas not as bad as it is now. So what does that suggest? It is crystal clear that oil demand isdeclining and oil prices will follow suit soon enough. In fact, oil prices have already begundeclining. Let us now look at two of the biggest oil consumers in the world the USA andChina.


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which is a pretty good figure, though it is still insufficient to make China to surpass theUSAs consumption in the near future. Thus, all this clearly indicates that the USA willcontinue to be the biggest influence on the oil market. India doesnt even show up in this

comparison, being only 3-4% of global oil consumption.

In the charts (Chart 3 and 4), both the USA and China (in spite of the Chinese governmentspartial control over oil prices) reflect the global trend (Chart 2). In other words, it can be seenthat though there have been some disruptions, the oil prices and growth in demand have beenmoving in the opposite directions.


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In 2007, Chinas consumption also slowed down to 4.3%, as mentioned earlier, as against ahigh of 7.8% in 2006. The following scenario analysis provides a rough idea about our viewon the growth in oil demand, considering estimates that we believe to be very conservative.

Assuming a consumption growth of 4% for China as well as India, (though India recorded agrowth of 6.5% in 2007, we have lowered the growth rate by 250 bps, considering the hike inprices of petroleum products and high inflation, coupled with the slower than expectedgrowth), along with a decline of 0.5% in US consumption and keeping consumption in othernations constant, the world consumption will grow by merely 0.42% in 2008, which is muchlower than the growth of 1.17% in 2007. In fact, the growth of 1.17% in world consumptionis also normal, taking into account the fact that consumption has increased by 8-9% (Y-o-Y)in the past.

Is crude oil supply really coming to an end?

While it is true that precise data on oil reserves is not easily available and how long reserveswould last cannot be accurately estimated, but whatever information that is publicly availablecertainly raises doubts over the grim scenario that has been portrayed for some time now


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about how the world is running out of oil. We continue to maintain our stand on the Reserveto Production (R/P) ratio that we had taken earlier

Quote 5

The present reserves to annual production ratio for the world is somewhere in the region

of 41-42 years. So, are we going to run out of oil by 2050?

Not so fastAn analysis of data shows that reserves/annual production ratio has

remained

Between 30-43 years for the last few decades.

A study of the historical data revealed that timing of most of the oil discoveries is random innature, though production is seen to influence price. Chart 7 shows the historical growth rateon proved reserve additions (irrespective of discoveries) from the period 1980-2007. Thegrowth rate generally moved in the range of -0.1 to 5% in this period, though it rose to14% in1986 and declined to -0.3% in 1990. In fact, from 1998 onwards, the proved reserves havebeen increasing, with a decline of 0.1% recorded only in 2007. Thus, even the historical datasubstantiates our view that the oil supply scenario is perfectly normal.


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But the data also raises the question as to why the reserve additions suddenly increased byalmost 14% in 1986, as the last big oil field discovered until then was in the year 1982 inRussia. The answer to this is the sudden announcement of an increase in proven reserves bysome OPEC members, which many believe was made in order for these countries to increasetheir exports, as the OPEC has a fixed quota for its members based on the reserves, as well asvery low oil prices prevailing back then, which forced these countries to increase their oilexports. It is not possible to calculate the amount of reserves that will be added and thenumber of giant fields that will be discovered in the future. However, as we had mentioned inour previous report on Global Energy, there are frontier areas and vast oceans that still lieunexplored, which hold the potential for oil discoveries, as was recently proved in Brazil.

Quote 4

It is true that many of the producing fields are getting depleted, but at the same time newdiscoveries are being added as the R/P ratio suggests. Recent examples being the

Kashagan field in Kazakhstan and the Santos Basin in Brazil current high prices and

scarcity psychology would induce more investments into the sector, thereby bringing in

otherwise inaccessible oil from the vast oceans and frontier areas into our homes and

automobiles

But then again, does all the noise over oil reserves really matter, as it is clear that more than

reserves; it is production that plays an important role. Anyway, forget about the long run, aswe are all dead by then (Keynes). As far as production is concerned, the OPEC has alreadyincreased its production by 0.7% and supply will also come from other sources, as allproducers will now try to rake in as much profit as possible by increasing production. Chinaahead of Olympics procured a large amount of petroleum products (gasoline, diesel) and afterthe games, this quantity would be released. Thus, the supply side scenario also indicates thatoil prices should decline. However, supply disruptions arising from sudden geo-political andnatural factors may result in a rebound in oil prices for some time (as witnessed after theBaku Tbilisi Ceyhan, BTC pipeline blast, which brought supply to Europe from Central Asia


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to a halt). But then again, the markets continue to discount this, with crude oil pricesdeclining despite claims by officials that BTC would take some time to resume operations.Going back to the issue of reserves, Table 2 shows the names of some major fieldsdiscovered after 2000, that is almost 20 years after the last giant field was discovered in thelate 1970s/early 1980s. These figures are primary estimates and are expected to increase, asmore and more areas are surveyed and the reserves in place ascertained. Further ifunexplored Iraq, Outer Continental Shelf Area (US), Arctic National Wildlife Refuge(Alaska US) and National Petroleum Reserve (Alaska, US) are to be included, another 170billion barrels should get added and again here also estimates are preliminary, as with moreexploration, more reserves will be added.

The above Table 2 gives demand forecast of crude oil over the next 10 years at a CAGR of

1.25%. A basic calculation reveals that, by 2017, a total of 333 billion barrels of crude oilwould be consumed. Now subtract this from the existing known reserves of 1237 billionbarrels and we get 904 billion barrels. If we add the new reserves to it, the figure comes toaround 1100 billion barrels and with consumption of 35 billion barrels yearly in 2017, theR/P ratio comes to 32 years. Then again, think of this: there are bound to additions toreserves over and above this number. Soon thing is certain, by 2017, the actual reserve figurewill be higher than 1100 billion barrels due to new discoveries, development in improved andenhanced oil recovery techniques, development of non-conventional crude oil like from tarsands, shale, and development of gas to liquid and coal to liquid technologies among others.


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Our TakeSome recent research reports suggest that not much exploration is taking place and BigOilcomprising of the super-majors like Exxonmobil, Chevron, BP etc) is spending more moneyin buying back shares rather than finding new reserves. It is case that Big Oil has been under

investing in E&P activities because they are themselves of the opinion that getting lockedinto long-term contracts for rigs and other equipment, at todays high rates, is not prudent,because the rates themselves are based on todays high oil prices, and these oil prices maynot sustain.Oil prices will continue sliding as the impact of demand destruction takes its toll, andsupplies become more visible. Moreover, new discoveries and their rapid development(Brazil has undertaken a massive offshore exploration and development program, USAsouter continental shelf area will also be opened soon), together with non-conventional oilfrom tar sands (which has led to an increase of 17 bn barrels in Canadas reserves to 27 bnbarrels by 2007), gas to oil etc., will make the supply situation very comfortable in future.Over the next 12-18 months, we expect oil prices to reach around $50 a barrel, which isroughly the same level from where the current oil bubble began. And who knows, we couldsee oil back at $30 over the next couple of years. Stranger things have happened in thisworld. After all, Oil was at $50 just about 1 years back.

1. Bubbles, a framework for analysis - http://groups.google.com/group/mphasis-capital-markets-community/web/on-financial-bubbles

2. From First Globals Energy Sector: Can the world overcome the energy crisis?dated August 1, 2008.

3. Western countries have been stating rising oil demand from India and China to bethe main cause of rising oil prices.

http://www.nytimes.com/2007/11/07/business/07cnd-energy.htmlhttp://www.financialexpress.com/old/latest_full_story.php?content_id=87094

4. From First Globals Energy Sector: Can the world overcome the energy crisis?dated August 1, 2008

5. From First Globals Energy Sector: Can the world overcome the energy crisis?dated August 1, 2008

6. The Article was published on August 14 th, 2008 by First Global (www.first-global.us) , when oil prices were at its peak.
http://groups.google.com/group/mphasis-capital-markets-community/web/on-financial-bubbleshttp://groups.google.com/group/mphasis-capital-markets-community/web/on-financial-bubbleshttp://www.nytimes.com/2007/11/07/business/07cnd-energy.htmlhttp://www.financialexpress.com/old/latest_full_story.php?content_id=87094http://www.first-global.us/http://www.first-global.us/http://groups.google.com/group/mphasis-capital-markets-community/web/on-financial-bubbleshttp://groups.google.com/group/mphasis-capital-markets-community/web/on-financial-bubbleshttp://www.nytimes.com/2007/11/07/business/07cnd-energy.htmlhttp://www.financialexpress.com/old/latest_full_story.php?content_id=87094http://www.first-global.us/http://www.first-global.us/

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