Will the bulls among you please calm down? Master Yoda will not use the force to lift prices back up! He is here to help all of us understand how to deal with oil. Believe it or not he is an expert with the stuff. Not because he has studied it, or worked in it, but because it is so similar to the Force. You only have to listen to his former students to get an insight into his philosophy. Oily Wan Kenobi, for instance, once remarked, “Oil surrounds us and transports us… It binds the economy together”. Even his evil disciple, Darth Trader, will tell you “the ability to lower rates is insignificant next to the power of Oil”.

By this stage, you probably all think I have lost my sanity, or spent too much time watching the new Star Wars trailer. Even though you may be right on both counts, you would still end up admitting that all pop culture aside, my Jedi friends are absolutely right. Oil only represents some 2% of global GDP, and may appear insignificant in relation to the remaining 98%. Yet, should you remove those 2%, the 98% will collapse. Look around you. Can you find anything around you that has not required oil to manufacture it or bring it to you? The food you eat, the clothes you wear… Oil definitely binds the modern economy together…

It is so important that demand for it is highly inelastic… Both ways! From US$ 10 to US$ 147 and back down, you have all happily kept driving, and heating your homes. It is the world’s only activity you cannot stop: Low prices, high prices, weather or war, boom or bust, oil must keep getting to the consumer. This should mean that as an investment, it would be diversified from price and the economy, and provide great growth potential and great returns… And this is where master Yoda feels a great disturbance in the force, as if thousands of investors cried out at once in despair, and closed their loss making positions. You can resume the situation like this:

Investor: “But I was told it would go up forever!”

Master Yoda: “That is why you fail…”

This is because all those who tell you to go long oil, are keeping the dark side of this asset class to themselves: Oil is also cyclical. They will tell you that freely in their analysis, but still always tell you to buy because it will keep going up…

Master Yoda: “If going up it is forever, then called cycle it should not be…

Trend it would be!”

Why is oil cyclical? Because of something we in the oil business call the “marginal barrel”. This is related to oil demand being inelastic. It takes a while for the market to react to an imbalance. Imagine there is demand for 1,000 barrels in the market and 1,000 barrels of supply. If demand increases by 1, and there is no spare capacity, price will rise until that demand is covered. Since the reaction is not immediate, prices may temporarily rise beyond the level necessary to provide that supply, and cause excess production. That is basically what happened with shale. Of course, this was not helped by publicity seeking individuals proclaiming the end of oil for the 623rd time! Once you have overproduction, prices drop and it takes time for consumers to adjust. Prices have almost halved, yet you haven’t started driving to the office twice a day. Prices may then overshoot, cause a reduction in investment leading to a later spike, and so on… Clearly, if you are planning to go long, it is only a matter of time before you get burnt because it is a cycle!

The current oil market situation is a case in point. Demand for oil is currently limited by poor economic performance in China and Europe, while demand in the US is growing at a pedestrian rate considering the drop in prices. Moreover the rate of this demand growth is slowing. Next year we are supposed to see demand growth of 1.2 to 1.5 million barrels a day depending on who you listen to. There is a current surplus in production of some 1.8 to 2.2 million barrels, so everything remaining equal, there will still be a surplus at the end of 2016! A return to higher prices will therefore depend on how the supply situation evolves.

Unfortunately, there are two major issues to consider. The first and most obvious one is called Iran. Granted, Iran would love higher prices, and it would love for OPEC to cut production… to make more room for an increase in Iranian oil exports! Iran claims it will increase exports by 500,000 barrels a day “immediately” upon the lifting of sanctions. Even Supreme Leader Khamenei has now approved the deal, so it could come into force within the next few weeks. Iran even says it will further increase production next year… so do Iraq, Mexico, Libya… etc…On the other hand, the EIA only expects US production to drop 300,000 barrels a day to 8.9 million next year. So the prognosis looks grim for a rally next year.

You will all point out that I believe the inflexion point will be in the course of the 2016 driving season and even I may be too early. But my prediction is based on the assumption that the bulls will capitulate before 2015 is over, dropping prices in the low 30’s, and accelerating well closures among inefficient producers. So the “bullish at all cost” legion should probably stop shooting itself in the foot.

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