The Staggering Collapse of Oil

First, the picture:

Stocks aren't the only thing heading straight down these days. If you needed any proof that inflation is not a threat, how does this chart suit you? Virtually all of the inflation that we have seen lately has come from high fuel prices. Well, those days are over.

This situation is not likely to change soon, either. Well, the perpendicular drop should stop, but a rebound, at least a sharp one, is not probably. A moribund economy will see to that. Oil inventories are also quite robust and demand isn't exactly whittling them down. Every financial crisis does have its silver linings. Falling interest rates and energy prices are among them.

Oil's Fair Market Value

This is a popular thread of conversation lately, and I've seen a few things that have piqued my interest in the subject of late.

One is this Marketwatch article that discusses the changing "break-even" price of oil in recent years. Basically, it's not so simple as just the mechanical break-even price of production, which is comparatively low in the OPEC countries almost uniformly (often sub $25 a barrel). It is a question of how much of a profit do they need to turn on their oil in order to satisfy growing political demands at home. According to the article, though this is difficult to verify, that price has increased from $30 a barrel to almost $85 since 2003.

I suspect a good portion of that might be quite recent as a consequence of the uprisings in the nations of the Arabian Peninsula and North Africa. Governments across the Middle East, especially Kuwait and Saudi Arabia, have opened up the fiscal spigots to quell the hot tempers of their simmering people, tired of corrupt and unresponsive governments that also do not reflect their religious values. To be sure, there is a split between more secular reformers and the religious fanatics in their motivations for reform, but the point remains that there is deep dissatisfaction and there should be, to be perfectly honest.

Atop this is the simple factor that supplies from Libya have been badly disrupted by the ongoing civil war there where one of the principal battlegrounds has been near one of the major oil distribution terminals. As oil's supply and demand curves are both highly inelastic in the short-term, that magnitude of disruption is difficult to discount. Similarly, oil traders have generally assigned a security premium of indeterminate value to the price of oil for fear of major disruptions.

The other major factor has been a recent/ongoing rout of the U.S. dollar versus virtually all currencies. However, this is a comparatively modest contributor and we can determine what that effect should be by simple arithmetic.

Working against oil is the fundamental fact that world stockpiles are sitting quite pretty at the moment.

U.S. stockpiles (Source: Energy Information Agency) are at very high levels indeed and the OECD as a whole is at the high-ish end of its range in terms of days of supply. Further, as consumption buckles and new production appears more attractive at current prices, the self-corrective mechanism of inventory builds is likely to take hold. However, I would caution against people who look at the current days of supply in oil and say, "Well, golly, why don't we have $30 a barrel oil again.". Things have changed since those old days and the world's oil supply has become fundamentally more difficult to get at and with it production costs have legitimately risen considerably. Cheap oil is simply no longer a possibility. What's more is that current markets are discounting the not too distant future in terms of both rising demand and more constricted supplies. 

Still, there is plenty of evidence that there is some intangible valuation going on with oil. A few weeks back, the price broke by nearly $10 in a single day. Healthy markets simply don't do that. I would struggle to tell you what oil's fair market value actually is, but I suspect that it is presently overvalued by 10-15%. I would not stake my life on such a bet, nor would I make a play like I did with options on silver. That was a clear cut bubble that could not be justified. This, on the other hand, is considerably more cryptic. 

Stay tuned. 

Beware USO For Long-term Holdings

One of the popular oil plays is the ETF USO, which is the U.S. Oil Fund. Basically, it is meant to track the price of oil itself, rather than derivative stock plays. Sounds good, right? Well, the problem is, like with many ETFs that track commodities, it doesn't really get the job done the way you think it might. 

So, oil is approximately 2/3s as high as it was at the peak in 2008. USO is at, oh, about 1/3 of the price. Due to the vagaries of how ETFs are often priced, these things don't track how they should over the long-term. You will see, however, that the long-term tracking issues have not dissuaded investors from piling into USO recently as seen by the volume spike. If you feel compelled to speculate on Middle East stability, this is fine in the short run, but bail as soon as you hit a target price, if you are so lucky. 

Geopolitical Instability and Oil Shocks

James Hamilton at Econbrowser has a post that's as good on this subject as I could hope to write: http://www.econbrowser.com/archives/2011/01/geopolitical_un.html

I suspect that the outcome in Egypt will not be one in which the country is run by a radical government that seeks to send the West a message by shutting down the Suez Canal, but the markets may be wise in slightly discounting that possibility.

An Interesting Look Back at Economic History

GDP data revisions sometimes can have the effect of re-framing our thoughts on the nature of the business cycle we just went through. For instance, the revisions released this morning showed something interesting about 2008.

The interesting thing to me was that Q3 2008 was simply wretched and much more so than we had previously thought. An annualized 4.0% contraction is fairly poor, though not entirely surprising given that Q3 was the quarter most heavily impacted by the ridiculous levels of oil prices at the time. That effect is borne out in the finer points of the data where consumer spending declines accounted for fully 2.5 points of that 4.0. This is what you would expect given the huge hit to purchasing power consumers took.

I think this confirms what James Hamilton over at Econbrowser has argued for some time which is that the oil shock in 2008 had a much larger contribution to the severity of that recession than we give it credit for. Bear in mind, Lehman collapsed in mid-September and its full effects were not really in place until the end of the month. Lehman's effect was mainly a Q4 event, and of course Q4 and Q1 2009 were simply abysmal quarters. However, it is clear that even without the collapse of Lehman that we were in the midst of a severe recession due to the combination of the grind of the housing collapse and the oil shock in 2008.

To some extent, other data revisions reflect this as non-farm payrolls were in very steep decline in the late summer of 2008 even before the effects of Lehman. Now the picture is a little more complete.