Posted on 03/01/2015 10:33:00 AM PST by ckilmer
March 1, 2015 | Comments (1)
Given the dramatic drop in the price of oil over the past few months, the burning question on a lot of minds is "What will the price of oil do next?" It seems like everyone has an opinion on that question. The range of predictions goes from $10 at the bottom to a staggering $200 a barrel at the top. What that range tells us is that where oil will go in the future is anyone's guess, and for the most part these price predictions do sound like guesses. Educated guesses, but guesses nonetheless.
The best guess, with a range of possibilities
One of the more educated guesses comes from the oil market itself. While many believe that the price of oil is set by a combination of supply and demand with a sprinkle of market sentiment, that's not entirely true. Its price is actually set by the oil futures market, which combines those factors into a future price for oil based on oil futures contracts. These binding agreements give the purchaser the right to buy oil at a predefined price and on a predefined date.
That future price of oil can be either higher or lower than the current price. If the future price is lower, then the market is said to be in backwardation. Meanwhile, if that future price is higher the market is said to be in contango.
Right now the market is in contango, which means that the market believes that the price of oil will be higher in the future. We see this in the following chart from the U.S. Energy Information Administration, or EIA, which is the government's official energy forecaster.
Source: EIA.
The above forecast is from the EIA's short-term energy outlook, which it updates each month. That chart indicates a number of forecasts, but the one we're interested in is the futures market price, which is the solid green line. From here we can see that at the moment the futures market is offering $60 a barrel for oil to be delivered a year from now, which is almost $10 per barrel higher than the current price.
That said, the market also offers a range of possible future oil prices based on the implied volatility, which are the dashed lines. These lines indicate that the market is very nervous, and while it is currently offering $60 a barrel for oil to be delivered later this year, it sees possible future prices for oil being anywhere in the range of $32 to $108 by this December.
That being said, the fact that the market is in contango at the moment is a bullish sign for future oil prices. This is why the EIA's official price forecast, the red line, is a bit higher. It's also why oil companies have decided to cut back on drilling so dramatically this year, as they see no point in bringing too many new wells online right now when they can earn more money by bringing those wells online in the future when the price of oil is expected to be higher.
A tango with contango
The CEO of top U.S. oil driller EOG Resources (NYSE: EOG ) , for example, noted on the company's last conference call that it was "intentionally delaying completions while we wait on improved product prices." It's the company's view that by waiting a few months to complete these wells it will earn a substantially higher return, which is demonstrated on the following slide.
Source: EOG Resources Investor Presentation.
By drilling wells, but not completing them, companies like EOG Resources are betting big that the market being in contango means that the price of oil will indeed be higher in the future. As the EOG Resources' slide noted, a move from the current $50 oil price to a $60 oil price over the next few months would boost its overall returns by 10%. With that key market signal in hand, EOG Resources and many of its peers are simply waiting out the market in order to capture that higher return.
Did the author publish a ‘key market signal’ before the unprecedented drop in prices recently?
It was the case that back in 2009 that oil prices went up quickly after it became clear that economies were growing and demand for oil was increasing. It may be that the same scenario is playing out here.
If so this would be unlike the situation in the 1990’s where low oil price persisted for years in the face of rising demand.
There goes my cheap gas!
The domestic oil production industry is shutting down high cost wells, and shedding bodies at a break-neck pace. This will help tighten supply, and boost the bottom line of producers. The wild card is the saudis and their deep cash reserves and the ability to dump cheap oil on the market for a protracted period, and essentially starve out the competition.
Doesn’t anyone remember the early 80’s and 90’s when they did the same exact thing? Remember the last time when oil was going for $10 a barrel, and wells were literally being capped and abandoned because the oil pumped wouldn’t even cover the cost of the electric bill to pump it?
Doesn’t anyone remember the early 80’s and 90’s when they did the same exact thing?
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What do think they are doing now?
Great question...
I thought Gary Shilling is a comedian. Now I’m sure of it.
In Alaska the price of gasoline goes UP very very fast with the crude oil prices change ONLY when it goes UP........
BUT go down very very very slowly when the price of crude oil changes downward... IF at all...
I suspect there are thieves in price structure mechanism..
You know.. parasites.. grifters.. democrats.. rogue republicans..
I smell fascism..
I thought it was 60?
No wonder I’m not rich.
Based on the current trends (i.e. gas/diesel is up almost $.50/gal in the past month) that oil will be going up ... $100/barrel? Maybe.
The oil companies/Arabs want their profits back.
And please, I don’t want to hear about high oil prices benefiting the economy ... we are all finally getting a break from the ridiculous $3.75 - $4.00/gal gas and now we are heading back to that phone/bologna price.
You can build your own tactical reserve of finished products.
I was told cheap fuel was bad for the economy. Just think when prices get back near 5 bucks a gallon, the economy will be on fire...Good times for all.
Oh boy! Let’s help the economy. I’m going to cheer on $5 a gallon gas! ... LOL ...
Agreed. Some days I when surfing, I run across "it's going up because" and the next article will claim "it's going down because". After a few days of that, I turn the whole "It's going . . ." scenario off.
Why wait? Just start paying $4/gal now. That way you can jump start the economy by yourself.
$1.98/9 here in mid-Missouri.
Gas is in the $2.40’s and diesel (what I’m concerned about the most) is now in the $3.30’s and climbing here in NH.
I guess it was fun while it lasted.
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