Forecasting the price of oil is risky

by Tom Stevenson, Investment Commentator at Fidelity International

May 2016

A large number of clever people backed by deep-pocketed employers spend a great deal of time trying to work out where the oil price is heading. It’s rather surprising, therefore, how wrong most of their predictions are. Forecasts generally amount to extrapolating the recent past. When the oil price hit US$150 a barrel in 2008, many thought that it would reach US$200; earlier this year when the price of Brent crude hit US$26, experts (often the same ones that were warning of the price spike eight years ago) predicted further falls to US$15.

In both cases, the pundits were left looking foolish as the oil price headed in the opposite direction. In May, a barrel of oil cost US$50 again for the first time in seven months. The oil price has doubled since January, confounding the bears and raising the question of just how far the rally can go from here.

There are several reasons why the price of crude has surged in recent weeks, most of them easy to understand but hard to predict. First, concerns about chronic oversupply have been allayed by output disruptions in a number of key producing countries. Militants in Nigeria have shut down production amounting to 1.4 million barrels a day, a 40% reduction on the recent peak level. Wildfires in Canada have knocked that country’s output by around a million barrels a day. War has taken its toll in Libya. The implosion of its economy is wreaking havoc in Venezuela. Stockpiles in the US fell by more than four million barrels in just one week in May, much more than expected.

Meanwhile, the other side of the equation is also putting upward pressure on the price. Demand is rising in the world’s biggest oil consumer as the US driving season gets under way against a positive backdrop of economic recovery and an improving jobs market. For an extended period we waited in vain for US consumers to spend the windfall of cheap energy; belatedly, they are now doing so. Consumption is rising in the world’s big emerging markets too. Chinese oil imports are up 12% this year. Consumption in India has risen 10% as car sales there hit a new record. Expectations of a rebalancing of the global oil market in the second half of 2016 looked optimistic a few weeks ago; today, they look sensible.

The implications of a resurgent oil price are significant and wide-ranging because many other investments are highly correlated with energy’s ups and downs. In particular, equity markets have marched in lock step with oil this year (somewhat counter-intuitively when you consider that cheap oil is in some ways akin to a tax cut for consumers). The reason for this close link is the way in which the oil price has come to be seen as a barometer of the health of the global economy. The doubling in the cost of Brent in recent months is a sign that the world is finally healing after the financial crisis. It is no coincidence that the stalled equity rally has picked up again in the last few days as oil has broken through US$50.

Rising oil means a nascent rise in US inflation (already higher than in other developed markets) can start to take hold. That in turn means the odds of the Federal Reserve hiking rates again in June or July are materially shorter than just a few weeks ago.

So how far can oil go? The lazy approach of extrapolating into the future argues for further gains from here. The recent slashing of exploration budgets by cash-strapped oil majors like Shell supports that call. It would be foolish to expect much more of the same, however, because the oil market is remarkably self-regulating. The best cure for a low oil price is precisely that low price. Dwindling returns make marginal production unviable and it quickly stops. We have seen that in the Shale fields of North America, which are pockmarked by wells that have been drilled and capped. But the same process also works in reverse. As oil rises above US$50 a barrel, these mothballed sites will be re-activated. At US$60 a barrel, new drilling will begin again. The US is the oil world’s new swing producer and Shale is much quicker to switch on and off than conventional production.

In the Middle East, too, the proxy war between Saudi Arabia and Iran means the taps are likely to be kept wide open. Riyadh isn’t going to give its regional rival a free pass by shutting down production while Tehran ramps up output into a rising price.

Expect the oil price to move broadly sideways from here in a new range between $40 and $60. But I offer that prediction with some trepidation. The past few years have shown that forecasting the oil price is a mug’s game.