Last week-end the Barron’s cover story was an article titled “Here comes $75 oil.”
I was going to run through all the infamous magazine covers that made dramatic predictions for oil at the exact wrong moment, when I came across this article from last year in, of all things – The Atlantic.
This article in a main stream publication, epitomizes the consensus opinion about oil. This sanguine view about the price and supply of oil runs deep through society.
However instead of just pointing at the overwhelming one sided view that crude oil will stay plentiful and cheap forever, let’s have a look at where the crude oil bears might be wrong.
Even though everyone is predicting lower energy prices, the market price is stubbornly refusing to agree with the bears predictions. Have a look at this 5 year chart of the price of spot crude:
WTI Spot Crude Oil</a> </div>
I find it ironic that many of the market pundits that use the strong stock market action to refute the bears’ worries are the very same ones who claim that in the case of crude oil they know better and that the crude oil market has got it wrong.
Crude oil is surprisingly strong and although the curve is in a steep backwardation due to the extreme long term bearishness, someone keeps buying the spot crude oil at $100:
Crude Oil curve</a> </div>
The demand for crude is higher than the bears realize.
Which brings me to the crux of my bull argument. Although I will acknowledge that the United States has indeed made a remarkable transition from the world’s largest oil importer to an increasingly self sufficient energy nation, the bears are focusing too much on this one piece of the puzzle.
Have a look at this chart of energy demand of developed vs developing nations:
More and more, the US is not the driver of the price of energy.
I have seen many frustrated traders who have simplistically looked at the ever increasing US supply and mistakenly shorted crude oil for the last year. I contend that if you are bullish on the US crude oil supply, a better way to express that trade is to buy US dollars. A US that doesn’t need to import as much energy will have a dramatically improved trade balance.
The Barrons’ article focuses too much on the new found supply and glosses over the increasing demand side of the argument. And when it does address the demand side, it optimistically outlines the ability to change to other cheaper fuels.
Let’s ignore for a moment that the move to natural gas in vehicles seems to be happening at a glacial pace. And let’s remember that although electric car use is increasing, that electricity doesn’t magically appear out of thin air and is often generated by fossil fuels. For a moment, let’s accept the Barrons’ argument about increase substitution in developed nations. If that is correct, we can assume the era of ever increasing energy demand from countries like the US is indeed behind us.
But what is going to happen to demand in China and other developing nations?
If you examine that energy use per person as a nation develops, there is a definite “hockey stick” pattern. As a nation develops and becomes wealthier, the energy use per person rises. It rises slowly at first until they hit a critical mass where there is enough wealth for the middle class to start buying cars, refrigertors, etc… At that point, the energy use per capital quickly rises.
Here is the chart over the last half dozen decades of the energy use of the Japan, Korea and China:
Energy Use per capita (in kg of oil equiv)</a> </div>
As Japan recovered from the Second World War in the 1960s and began to rebuild their destroyed economy, there was a boom where energy use quickly went up more than 2.5 times in a decade. Same thing with Korea in the 1980s.
China has just started this rise and unless you think there is some reason China cannot repeat the economic success of Japan and Korea, you have to assume ever increasing demand out of China in the coming decades.
But how much is that going to be?
Even though China’s oil consumption per person is still very low, that little blip higher over the last decade has been enough to move China into the number two consumer of oil.
Now imagine what happens if China’s oil consumption per capita follows the path of Japan and Korea. They will very quickly be the number one consumer of oil.
You can talk all you want about the supply side increasing, but the demand side is going to overwhelm any increase in supply. We have not even discussed India and all the other developing nations.
As the rest of the world becomes richer, they are going to use more oil – lots of it. The oil bears discuss the increasing alternative sources of energy and all I can say is – bring it on as we are going to need it!
There are other problems with the Barrons’ article regarding the assumed cost of production for this new supply, but instead of rehashing those arguments, I suggest you go look at this great article on Seeking Alpha.
And then finally, we have not even discussed the potential for the massive monetary expansion of the last half decade kicking in. What do you think happens to the price of oil if the velocity of money stops going down and the mind blowingly large Central Bank injections finally gain traction?
I know that when you see articles in Barrons that seems to paint a bleak prospect for the future price of oil it makes being a bull more difficult. The argument seems to make sense and it is easy to focus on that one aspect of the big picture and get really bearish.
However, ask yourself if the market is really this inefficient. Ask yourself where the surprises are going to come from. And ask yourself if $75 is the downside, what does the other side look like? Is the upside only $125 oil?
And then finally, the best indicator that I have for my bullishness is that everyone, and I mean everyone, thinks I am nuts. This is the loneliest trade that I have on… Which probably means it is the best one…
What will happen if the crude oil bears are wrong…</a> </div>