Since early June the oil markets have been in both bull and bear markets, as represented by the price swings in West Texas Intermediate (WTI). We see all this volatility while the stock and bond markets do well and the VIX is asleep.
So why is oil so volatile, and where is it going? In this long oversupplied oil market, prices appear to be whipped around by sentiment regarding world growth and rumors from OPEC, led by Saudi princes. All of these factors are hard to quantify and wild rumors and speculation lead to wide swings.
But where should oil trade? At the end of the day, and in a balanced market, we believe the price of oil should settle around the marginal cost of production. That’s our theory, and theories are useful for projecting an outcome or a timetable. However, it is rarely wise to project both at the same time!
Balance between supply and demand is slowly returning to the oil markets, as indicted in the chart below. The Energy Information Administration (“EIA”) is projecting balance due to a drawdown of inventories over the next year. We don’t know exactly when, but we believe oil markets will again come into balance, and once the market comes into balance it can move toward the marginal cost of production. Predicting this cost is not an easy undertaking because of the multitude of variables involved, but reasonable estimates are now in the range of $60-$75 per barrel, depending on the state of world economic growth.
So while the bulls and bears are currently dancing cheek to cheek, we believe the bulls will lead over the intermediate time frame. Nonetheless, there is still plenty of time to fill the tank with cheap gas and take a Labor Day road trip!
Source: EIA, Bloomberg, OPEC, IMF, BP