Where is the Floor in Crude Oil?

January 22, 2015

In recent weeks R^2 has been asked “How low can oil prices go?” This is the wrong question. John Maynard Keynes said “Markets can remain irrational longer than you and I can remain solvent.” His point was that it is foolish to believe that anyone can consistently identify market tops or bottoms. They are impossible to pick. The more important question focuses on the sharply contrasting risks one faces in a high vs. low priced market. When prices were high, R^2 consistently advised producer clients to hedge, attempting to avoid all attempts to pick a top. The risk of under-performing hedges was real, but never jeopardized client cash flows. Bottom picking is a much more serious matter. Most businesses fail when cash flows are inadequate. It is our opinion that every producer client should carefully consider their ability to withstand a long period of low prices. With that said, it is important to understand what is possible. In recent years we have brought to your attention the Oil Expense Indicator. In simple terms, it is the measure of how much money is being spent on oil as a percentage of world economic activity. Current demand is ~92MM bbls/day. If one multiplies the amount of barrels consumed in a year by oil’s current price, and then divides that product by world GDP, we get the resulting chart:

 Crude Oil currently runs at an expense of ~2.3% of world GDP. The average over the last 25 years has been 2.8% of world GDP. This implies that with WTI prices at $50 and Brent at $53, the price is running a little bit below an average of ~$63/bbl which can be supported by the world economy (at 2.8%). But as the chart demonstrates, prices can remain overvalued or undervalued for considerable periods of time. If WTI went to $35, that price would imply a ~1.6% Oil Expense. Given that this is on the lower end of the chart, we would not expect prices to persist at this level for very long. Cheap oil would stimulate demand and curb incentives to create new supplies. Keeping in mind that there are many moving parts, eventually economic and population growth will spur a return to higher prices.

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