Oil Price Scenarios - Engineered forecasts are insightful, but inevitably wrong

I've spent a lot of time building financial models, and gathering primary and secondary data to feed into those models. What I can tell CEO's of oil and oil service companies, and analysts of all stripes, is that the process is valuable, but the forecast is not. 

Here's a great example:

[Via RBN Energy's Sandy Fielden (who I think happens to produce excellent research) on an analysis of a Turner Mason & Co. report]

The value in this report is not the conclusion, which is repeated here:

 

That forecast is just wrong on several levels.

The premise of attaining supply/demand equilibrium in capital intensive commodity markets is just false. It is a rare case that only happens by accident, and only for brief snapshots in time. Because there are so many variables that act as stimuli on both supply and demand, and because of the staggered, and often lengthy lead times between decision-making and response - I would posit thatcommodity markets are almost always out of equilibrium

Large, supply side projects can run 5 to 10 years between the initial decision to invest and subsequent output. That is well beyond any visible certainty into supply/demand dynamics.  

Given the huge disparity between capital investment economics (the price of oil that makes people want to invest) and the marginal production economics (the price of oil that makes people shut off current production), compounded by different costs of capital and non-financial motivations of certain decisions by significant players, the supply/demand model is one that doesn't naturally trend toward equilibrium, but rather one that is constantly shooting past equilibrium.

commodity markets are almost always out of equilibrium

Moreover, in direct contrast to the conclusion of this report, which suggests lower price volatility will result from a sustained period of supply/demand equilibrium, I posit that price volatility spikes as we blow past equilibrium, and settles when it is clear to all participants that we are over or under-supplied. 

Price volatility is the embodiment of the clash between different future expectations. It is the inverse of the dispersion of consensus; that is, when everyone sees the same future, and consensus rises, price volatility falls. Thus, we can observe that volatility fell during the most recent period of 2010-2014 as we were in a consistent stage of undersupply.

During 2014-2015, volatility spiked as consensus broke down. Growing inventories debunked a worldview of an $80-$100 price floor. The theory that the purely-economic motivated shale players would act as a swing producer, cutting production in step with pricing, proved false. It's taken a year of high inventories and falling pricing to dispel that worldview.

volatility spikes as we blow past equilibrium

During 2016, I'd expect price volatility to settle down, as everyone embraces a "lower for longer" outlook.

Yet as consensus grows for lower pricing farther into the future, more investment will be curtailed. Where analysts are projecting "equilibrium" between supply and demand anywhere from the end of 2016 to 2019, I see the probability of an overshoot growing.

Whereas even the quick-cycle shale players have been unable to navigate the changed short-term environment, imagine the impact of today's underinvestment in deepwater and the arctic in 5 to 10 years.  

Do note - this underinvestment is clear and visible. Thus, I don't expect us to be stuck in an oversupplied market until the physical shortage is evident in 5 years. I would expect that the expectation of shortage will be one of the contributing factors of yet another missed "equilibrium", and the catalyst for another spike in volatility. 

And all of this without even considering the wildcards of geopolitics and demand:

  • There's a war in the heart of the middle east (not the first time, mind you) that unlike the Iran-Iraq war has drawn in both regional (Turkey, Saudi Arabia, Iran) and global (Russia, Nato) participants hell-bent on pursuing objectives that are not purely economic in motivation.
  • In addition, the future trajectory of the Chinese economy is quite unclear.

 

The details are where the value of engineered forecasts are hidden

Despite my reluctance to embrace the conclusions of an engineered forecast, most specifically its approach to price volatility and supply-demand equilibrium, there is a huge value in taking a look at the details. Understanding the potential impact of a greater proportions of light crude supply, changing trade flows, and the capacity and capabilities of future refining are valuable in gauging the sensitivity and relative importance of specific data points as the future reveals itself. This is why this work is valuable.

Management should plan for uncertainty, not around consensus projections

Building an investment scenario around consensus projections is just socially acceptable gambling. I say socially acceptable because you can usually get funded to make these types of investments, and if things go wrong, you can usually escape blame by saying it was the market's fault.

What more management's need to be doing, and more investors need to be supporting, is positioning and investing in expectation of future change, not trend persistence. The most undervalued assets are embedded, long-term asset options. Management's that create and own real options are the one's that can afford to react when things change, and opportunities present themselves. 

The most undervalued assets are embedded, long-term asset options.

A quick example - EOG has built up a significant inventory of drilled-but-not-completed wells in North American shale formations. This is a very straightforward example of creating real option value. 

Investors should be investing in relative volatility

Financial investors would be well advised to embrace the uncertainty in oil markets now. While the price drop in 2015 drives most investors away, now is precisely the time one should be spending more time investigating opportunities.

While today's headlines proclaiming that OPEC is dead, and oil prices will stay "Lower for Longer", experience tells us there's always another surprise around the corner. Given our outlook for lower volatility going into 2016, and higher volatility in 2018 and beyond, beit through real assets or financial ones, the optimal investment  right now is funding long-term vol by selling short-term vol.