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Oil recently had a nice three day rally of about 20%. Suddenly the “gloom and doom” about this complex vanished and analysts were quick to conclude that a bottom in oil had been made. I say, “not so fast.”
Oil (light crude index) had a 59% decline ($63) going into the low of January 28. A $9 rally is just a bounce from the low, probably maneuvered by the high frequency trading operations to squeeze the overwhelming number of shorts. It worked. But it never works for very long. After a pullback, it might even go higher to make sure the shorts don’t get so blatantly overconfident.
But a bear market rally does not make a bottom until the fundamentals change. Currently, there is a glut of oil globally. The culprit: fracking in the US and big discoveries internationally.
Furthermore, the globe is shifting into alternative energies. Although that’s only a very small portion of energy supply, it is gaining ground, especially solar.
At the same time, the global economies are weakening. That causes a reduction in energy demand.
On January 12, 2015, a major Wall Street firm cut its oil price forecast by about 40%. Anyone who had acted on their previous price targets is at best experiencing great financial pain.
Their forecasts on WTI Oil (West Texas crude), for 3-, 6- and 12-month out prices were cut to $41, $39 and $65 respectively, from $70, $75 and $80 a barrel. That’s a big revision.
That firm hedged these forecasts with a statement, in case the prices dropped lower:
“While history would suggest that a storage blow-out would push spot prices below $35, we believe … the market will hover around $40, potentially dipping at times into the high $30s which we see as the likely lows of this cycle.”
That reminds me of this high-profile firm’s forecast in mid-2008: they raised their forecast for the price of oil to $200. At the same time, I had gotten “sell” signals on my analysis and had predicted oil to drop to plunge to $50. My fundamental analysis supporting that technical target was my forecast of an immense global financial crisis.
Oil actually got down to $38 in late 2008. The global crisis occurred and oil demand diminished. Oil tankers were actually used as storage bins for oil, just as they are now.
Let’s look at supply and demand for oil:
About two years ago, another widely publicized theory made the rounds, saying that “peak supply” of oil had been seen in the world. It was said that the available supply would decline significantly over the long term, possibly jeopardizing the world economies as energy became scarce.
That theory was highly questionable to me. Over the past 40 years, whenever the price of oil soared, the pundits would say “the world is running out of oil.” In our Wellington Letter, each time I heard the pundits say this, I wrote that there were many very large, untapped reserves of oil everywhere. Now we see that this is true.
New methods for drilling, and flying over areas with sophisticated electronics to discover new fields, have increased known reserves significantly. Some internal numbers of oil companies say that there is enough oil to supply the world for next 500-1000 years. That will obviously not be publicized.
In a conversation with a big energy bull in 2007, who eventually lost $2.5 billion in the 2008 oil price plunge when he bet on higher oil prices, I said that the big story was demand over the next few years, which we expected to decline and cause a glut. He obviously didn’t agree.
Currently, we and others can cite mind-numbing statistics of oil production, global consumption, oil reserves in the ground, etc. But the fact is that many of these numbers are not true. When it comes to oil inventories, do they count the oil in tankers at anchor, used by speculators as storage bins?
The big financial and physical commodity firms have been very good at hiding commodity gluts, from copper, to aluminum, to oil, and others in order to manipulate the prices. Class Action law suits have been settled by these financial firms. The regulators have sued them. It happens. Never assume that these numbers are accurate.
What do I foresee now? I have this contrarian view:
The plunge in oil prices will exacerbate the oil glut for a while because producers in the US, and member countries of OPEC abroad, will offset the declining prices by pumping even more oil.
However, the very long term story for the next 20 years and more will be “Peak Demand.”
In other words, instead of oil facing diminishing supply, the new long term trend for oil will be ruled by diminishing demand. OPEC and other oil producers will experience severe pain. This will accelerate the global deflationary trends. The emerging countries will suffer significantly.
On the supply side, alternatives, especially solar, will replace the 100 year dominance of oil in energy. Tesla is already using its battery technology to store electricity for buildings. Solar City, also controlled by Tesla founder Elon Musk, is using this technology. It will be easy to have central charging stations, fueled by large solar cells, to charge cars and trucks, or even railroad engines. The energy revolution is here. In 15-20 years, we won’t have the traditional gasoline engines in cars. They will be electric.
The global economies are in a long-term deflationary wave. Japan, since the peak in 1990, is a good road map or what may be ahead for the world, although most analysts would never agree with that. The government bond markets of the world are forecasting this trend as yields decline to 500 year lows.
In Europe, several countries now have negative interest rates on government debt, meaning below zero. In other words, the investor must pay the government interest for the pleasure of lending money to the government. Unusual? You bet!
No one alive has ever seen times like these. It is not smart to pretend that these are normal times.
Japan has been in a period of deflation for about 24 years. It is plagued by ever soaring debt, and now has one of the highest debt to GDP ratios of an industrialized country. The massive stimuli from the government and its central bank have not caused a recovery. In fact, they have delayed it. Yet, central banks from China, to Europe, and to the US are carrying out the same policies.
If we look at Japan’s inflation rate, over the past 30 years, the peak inflation during that time was 5.4% in 1990. This caused the government to tighten money severely. At the time, we wrote in the Wellington Letter that these measures would cause at least a 10 year recession in Japan. We underestimated the impact.
The low of inflation in Japan was below zero in 2009, the depth of the global crisis. Now it is around 1.6%. If we go from high to low, it was 19 year period. If the globe has a similar experience, and we measure from 2007, we get a potential deflation bottom in 2026. If we measure from the year 2000, which by many measures was an important peak year economically, then 2019 would be a bottom in deflation.
The idea of “peak demand” for oil, as the global economies stagnate and don’t recover, while the supply of oil continues to increase, is likely to put more pressure on the price of oil. If oil has the same percentage price decline as from the 2008 peak of $149 to $38, then oil could go to the $28-$32 area, depending on the contract.
The global repercussions in the financial markets are enormous and in my opinion, strongly underappreciated by those who say that the low oil price is positive. If oil goes lower, will the stock market reflect the deflationary consequences? Those are the very important questions we analyze continuously for our clients.
As the professional hockey player Wayne Gretzky advised, look for where the puck is going to be, not where it is now. And that’s what we try to do Dohmen Capital Research, where we are usually on the other side of the crowd. If the crowd were always right, then the crowd would be very rich.
Wishing you successful investing,
Bert Dohmen, Founder
Dohmen Capital Research, Inc.