“Prediction is extremely difficult, especially about the future”: Niels Bohr
Once upon a time everything was predictable. Rating agencies could “almost” guarantee negligible default rates on bonds bearing pretty AAA investment grade stickers. And as the free-world slumbered, Noble Prize-winning economists fiddled with (fiendishly) clever theories like Inflation Targeting and the Black–Scholes-Model, which (theoretically) were going to create immense wealth out of thin air.
But sadly a “flaw” was found, (well more than one actually), and the predictions didn’t work out quite as planned. Sigh!!
All the same, my niece (aged six) can predict where the sun will come up and also, where it will go down, with extraordinary precision.
So Oil Prices shouldn’t be too hard…Right?
The price of oil “ought” to depend on three things (1) supply (2) demand (3) the extent to which the market is manipulated (bubbles).
Short-term, supply is not very elastic, neither is demand. But one thing no-one can dispute is that from time-to-time the market is subject to manipulation by both buyers and sellers.
That’s what H.H. Prince Turki Al Faisal Al Saud was talking about the other day when he declared that Saudi Arabia is committed to playing its part in facilitating recovery of the World Economy, by making sure that oil is sold at a “Fair Price”.
Well, that’s dandy isn’t it? He didn’t elaborate on how Saudi Arabia had transformed itself from what the western media once used to characterise as an “economic-terrorist”, to a “fairy-godmother-of-last resort”. But what he was saying was clear; Saudi will manipulate the market to bring the price down if they think it’s not “Fair”. That’s manipulation just as much as when they acted as “swing producer” in the 1980’s to keep the price high.
So price is easy to predict, the Saudi’s say $70 to $80 is “Fair”, therefore that’s what the price will be.
That wasn’t so hard!!
But then, is that the “right” price?
How about if “fundamentally”, the total amount of money “The Whole World” can afford to pay for oil is a constant percentage of GDP, and over the long-term that’s what they will pay, regardless of how much oil they get?
That’s not exactly Adam Smith. But imagine if (a) suddenly there was no oil, GDP as we know it would head in the direction of zero (b) the Saudi’s magically turned on the taps and the amount of oil consumed was double what it is today, at half the price, GDP wouldn’t double. So perhaps, somewhere between those two extremes, there is an optimal?
Another word for that idea is “Parasite Economics”: http://seekingalpha.com/article/140546...
In the language of economists that “theory” says the “Fundamental” price Of Oil Today which I shall call “FOOT” is equal to the Total of All de-World GDP today (which I shall call “TOAD”), multiplied by “3.33%”, and divided by the amount of Oil consumed (with a “k”), which I shall call “OIK”.
“FOOT” = “TOAD” multiplied by “3.33%”” divided by “OIK”
Crazy theory Eh!!
If that’s right then if you plot the “model” against the reality, there will be a “correlation”, which won’t necessarily prove its right, but will at least prove it might be right. If there isn’t a decent correlation then that’s proof the “theory” can get put on the scrap-heap, like those other theories from “once-upon-a-time”, which had “flaws”.
According to this convoluted line of reasoning (the “theory), the red line on the chart is the “fundamental”.
As you can see, it’s not a very good predictor of the black line (the actual price of oil); in fact year-on-year it only explains 62% of changes in the oil price since 1970.
Put that another way, 95% of the time it predicts the price of oil with an accuracy of plus or minus 75% which is not much better than a blind chimpanzee with a dart board.
So much for that theory!
If my niece could only predict where the sun would come up with an accuracy of plus or minus 75%, ninety-five percent of the time (and a lot worse than that for the remaining 5% of the time); well we would be tempted to feed her Ritalin.
Except for one thing:
One reason that the “fundamental” (“FOOT”) might not have predicted the oil price very accurately over the past forty years; is that the price of oil might have been manipulated from time to time.
Horror…now you tell me!! That is preposterous…what about the Cast-in-Stone theory of “Efficient Market Hypothesis”, the one that says markets never-lie, could anyone in their right mind really be proposing that the fundamental assumption that lies at the bedrock of our sacred economic universe, has got a “flaw”?!!
Like in; “Assumption is the Mother of all Frappuccino’s”.
What happens when markets are manipulated upwards (by whatever means), is that you can get a “bubble” which is where the price ends up a lot more than the “fundamental”. The next thing that happens is that there are “mal-investments” that only make sense at “bubble prices”.
Then the bubble pops, and since bubbles are zero-sum, the next thing that has to happen is that prices have to stay much lower than the “fundamental” until all of the mal-investments are washed clean (i.e. the foolish mal-investors lose their shirts, or if they are smart, they get foolish taxpayers to loose theirs instead).
For example, in the case of oil, one of the big “mal-investments” in the 1980’s was North Sea Oil which had a breakeven of $12, which sounded great at $40.
And then the bubble burst, so all the expensive production capacity that had been bought on credit, got to be “underwater” (no pun intended); which is how the English ended up stealing all of Scotland’s oil and selling it at the bottom of the market.
Of course one mustn’t forget the Law of “What-Goes-Around-Comes-Around”, which explains how come Bonnie Prince George Brown (presumably for a modest consideration), sold off all of the Bank of England’s gold at the bottom of the market, which proves conclusively that it’s never a good idea to get between a Scotsman and his Sporran.
Interestingly prior to 1973, the oil producers, particularly the Shah of Iran, were complaining that the “Seven Sisters” were manipulating the price of oil down.
Looking at the chart, perhaps he was right, although it didn’t do him much good, because he got branded as a “loose-cannon-biting-the-hand-that-feeds”. And so when the Iranian population started to be revolting, no one lobbied on his behalf in the places that mattered, and he got hung out to dry.
So much for the grand theory; the practical value of “BubbleOmics” is that you can figure out precisely where the fundamental really was (that’s the red line) by comparing the top of the bubble with the bottom of the slump that follows.
Perhaps that can explain the “fundamental” mystery for why “FOOT” is such a lousy explanatory variable for the price of oil?
According to the 7 Immutable Laws of BubbleOmics, short-lived bubbles, like the oil-bubble in 2008 where the fundamental won’t have changed much (in the short-term demand for oil is not driven by price), the “fundamental” (that’s what International Valuation Standards calls “Other-than-market-Value which is what the price ought to be if the market was not being manipulated), is defined as the square-root of the “top” multiplied by the “bottom”. That’s a pretty universal characteristic of bubbles, and most of the time it’s pretty accurate:
Do the arithmetic for the recent bubble in oil-prices taking say the 30-day MA i.e. the square-root of ($127 x $46.5); that gives you the “fundamental” in early 2009 at $76.5 which is a way of calibrating the fundamental line.
That’s illustrated in this chart:
Oh my Goodness!! The “fundamental” worked out by BubbleOmics is slap-bang on the line of the “fundamental” worked out by Parasite Economics!!
But perhaps that’s a coincidence?
Well there is one way to check that out, because there is another point of reference, which is/was the collapse of the 1980’s oil bubble.
BubbleOmics also says that extent of the under-valuation reference the fundamental, after a “pop” is exactly equal to the extent of the over-valuation in the preceding bubble (that’s mathematically the same as the square-root storyline).
Well at the top of the 1980’s bubble oil was selling at 2x the “fundamental” as it’s calculated here…and then it went down to half the fundamental…that fits.
But OK…just one line and two points worked out by Third-Grade arithmetic…that’s hardly Black-Scholes!!
Why that’s interesting is you got ONE simple line that comes out of dividing one “clean” string of numbers by another “clean” string of numbers (by that I mean numbers which are consistently reported and not dramatically manipulated), that gives you a best fit with a constant of about 3.33%.
Then you got TWO points that came out of a completely different line of logic, based simply on multiplying two public domain numbers together, and 3.33% pops out too.
That’s three coincidences, well four actually; this is what I posted in October last year:
It’s highly unlikely oil prices will go down much although typically the periodicity of a bust is the same as a bubble (this time about 18 months), so expect oil to head up towards $80 by April… then the price should bubble along and quite possibly hit $90 by the end of 2010.
So here we are in the twilight of 2010 and oil prices are knocking on the door of $90, and as my niece will tell you, the acid test on a model, is can you do it in real-time?
Like a hard number, not something vague like “cover-your-shorts” or “the-train-left-the- station”, a number, predicted one year in advance.
Most people think of a bubble as when prices are manipulated upwards above the “fundamental”, that leads to “mal-investments”, etc…etc, and so you get a slump afterwards which typically lasts as long as the previous bubble.
But you can have reverse bubbles; those start off when prices are manipulated down which leads to sub-optimal investment in new capacity, maintenance and development of alternatives. One example of that is rent control, which pushes prices down, but that creates bubbles downstream in the “non-controlled” parts of real-estate markets which is one of the reasons there was a bubble in Dubai property.
It looks like that happened prior to 1973 for oil. When Iran and Iraq stopped pumping on account of deciding to spend ten years trying to blow each other up, there was no spare capacity because there had not been enough investment…because there wasn’t the money in oil to pay for it, or a reason to invest in energy conservation.
Thus the bubble that followed was arguably “caused” by the previous manipulation of prices (down) by the “Seven Sisters” prior to 1973. And perhaps all that stuff about “Arab Solidarity” and “throwing Israel into the sea”, was just hot-air to justify the price increases? Certainly in the event, what happened is that after they got the price they liked, any traces of solidarity disappeared into the mirage.
Perhaps there was also a reverse-bubble created starting in 1997 when according to the “theory” prices should have been heading back towards the fundamental (Point “D”).
Then there was the Asian Crisis which can’t be easily explained by this analysis; perhaps the Saudi’s persuaded themselves or were persuaded to “be Fair” so as to promote world economic growth, then things recovered and prices started to go up towards point “C”. And then there was 9/11.
9/11 was a big shock for America, but it was even more of a shock for the Royal Family in Saudi Arabia.
The official “logic” for the invasion of Afghanistan and Iraq; has been watered down to:
1: The West must ensure that “failed-states” cannot harbour terrorists.
2: In order to achieve that, an approximation of a “Western-style-democracy” must be put in place in the “failed-states” that don’t go along with Item (1).
OK so putting aside all that talk about “bunkers” and “command and control” that has been attributed to Al Qaeda, the message is clear that under the “New-World-Order”, states which “harbour” terrorists are, in the immortal words of Donald Rumsfeld, going to get carpet-bombed “back to the Stone Ages”, and then what’s left will be forced to adopt the joys of Western Style Democracy.
Such is the politics of self-delusion, that no one noticed there is an inconsistency in that “logic”. Fifteen out of the nineteen terrorists in the 9/11 atrocity, were not just “harboured” by Saudi Arabia, they were born and bred there. And none of the remaining four had been either harboured by Iraq or Afghanistan or were born or bred there.
And the evil-cave-man who financed the attack, and these days most people think that’s about all he did, plus go “blah…blah…blah” on Al Jazeira, was also born and bred in Saudi Arabia. Plus he got the money for his little “sponsored” adventure (about $500,000), from Saudi Arabia too; and it’s highly likely it was not from his family (the Bin Laden Group), because he had been cut off years before.
So reference the $3 trillion that some analysts say the Iraq and Afghanistan campaigns will have cost by the time they are over, it’s hard not to wonder why that wasn’t spent carpet-bombing and invading countries or places that DID and DO harbour terrorists who are fanatically bent on destruction of the “free-world”; like Sudan, Egypt, Morocco, UAE, Indonesia, Pakistan, and even Leeds in UK and Hamburg in Germany, and well….Saudi Arabia.
Come to think of it, how about that McVeigh fellow, wasn’t he a terrorist who got caught up in the emotion of religion getting perverted, the only difference was that then it was Christianity in Waco Texas, and now it’s Islam.
I put that omission in prioritization over who should be carpet-bombed, down to the rare but sadly incurable, condition called “Geographic Dyslexia”. Which I suspect has some viral connection with the Black-Scholes-Model; based on the well known fact that LTCM thought Russia was in South America.
Perhaps there is another explanation?
Regardless, Saudi Arabia was not “Bombed-back-to-the Stone-Ages”, nor was a “Western-style-Democracy” imposed on them either, and in fact no one ever mentioned that idea.
I wonder why not?
Perhaps there was a quiet “quid-pro-quo”, and the Saudi’s promised to set-aside their old ideas of being “Economic-Terrorists”, and commit to becoming the “Fairy-Godmother-of-Last-Resort”, with regard to oil prices?
Sort of like an “Oops…SORRY!!” moment?
And so they pumped and they pumped and they pumped and they pumped, for all they were worth. Which was great …short-term, and for me in particular and my beloved Land Cruiser, except that caused a “reverse bubble”.
And then they could pump no more. And then, the result of so many years under-investment in oil or in substitutes for oil; produced a “reverse-pop”, which might have been one of the reasons for the bubble in 2008?
The numbers sort of pan out; depending on where you draw the line, by that logic the fallout from 9/11 might have caused a reverse bubble and brought prices down to 1/1.75 of the fundamental, which is about how much prices got inflated in the 2008 bubble, and the timings are in synch too!!
So how much oil has Saudi really got?
There is another point here, which is the question of how much oil Saudi actually has that it can pump out so as to “be a responsible world citizen”. They say they have 246 billion barrels which is enough to supply the whole world for ten whole years.
TEN Years Eh!! That’s pretty good, nothing to worry about!!
Err and after that? Err…and maybe they are lying?
Perhaps the Saudi’s story-line when (if) they were negotiating about the possibility of getting carpet bombed and then having a Western-style-Democracy imposed on them, which incidentally would have meant getting rid of the Saudi Royal Family (which incidentally was one of the aims of the mad-evil-genius-caveman), perhaps they were tempted to say…”don’t worry we have easily enough oil to keep the price down…forever and ever…trust us!!”
Except there are some people (pretty smart ones at that), who say that’s not true; although until Wiki-Leaks manages to come up with any evidence of that, no one will know…until perhaps Saudi starts to seriously run out of cheap and easy to extract oil.
There is a clue there though. When Prince Turki was justifying the Saudi “target” of $70 to $80 he didn’t say, “That’s how much money we think we can suck out of the world without it suffering too much”, he said, “That’s what it will cost us to invest properly in the new capacity to be able to pump”.
But it costs less that $6 per barrel to pump the “easy to extract” oil out of Saudi, so what are they worried about?
What happens if Saudi Runs Out Of Oil?
If the Saudis are being economical with the truth about how much oil they have, that could be a game changer.
Up to now, the supply of oil to the world has been dictated by how much the oil producers WANT to pump not particularly what they CAN pump if they set their minds to it; plus the buyers have done their bit to persuade, cajole, and force them, to pump “enough” to keep the price “right”, at least as determined by their own interests.
But the recent “admission” by IEA that they had been fudging their books for the past ten years was as significant an event in the “oil-world” as, for the rest of us, the announcement that the Roman Catholic Church has approved the use of condoms (in certain proscribed circumstances that would not be appropriate to elaborate on in a “family orientated” publication).
What those two announcements have very much in common is that they are an admission of past delusions.
But if the proponents of Peak Oil are right AND the spread of HIV is slowed thanks to increased condom utilization (affects GDP), then quite soon the way that the oil market worked over the past forty-years would become irrelevant.
Because in that case the “correct” way to price oil would not be determined by consideration of how much blood to safely suck (Parasite Economics), it would be at the replacement cost.
No one knows what that is, and if they do they are not telling. Sure at $75 it makes sense to start to re-open the shale fields, and to keep going after deep-water oil, but there is no telling how-much those sources will cost to bring in, once 30% or 50% of the world’s needs are from that source. The easy stuff is cheap; then costs start to go up exponentially.
Interestingly the price of gold, which traditionally is a good marker for the price of oil (and vice versa), at $1,300, is signalling $138 oil.
Then there is the threat of war:
One of the ironies of the recent invasion of Iraq is that it achieved, for Iran, exactly what they wanted to achieve after they repulsed the Iraqi invasion of 1980, and then went in hot pursuit across the border to try and secure Basra.
Once it looked like the Iranians were winning there were intense diplomatic efforts by Iraq’s backers, which included generous offers of restitution. The backers at the time were Saudi Arabia who were helping finance the war and sending ordinance in dump trucks with steel plates welded across the top so no one could see in (I did), plus there was the West who were helping out with more exotic ordinance for example satellite imagery (USA) and poison gas sourced from Portugal and Germany, which incidentally proves that Nuremburg didn’t put an end to Germany’s glorious technological lead in that particular speciality.
But Iran’s intractable mullah’s refused to listen to “reason”.
They had two conditions which were non-negotiable (1) Saddam Hussein had to go (2) a “Western-Style-Democracy” should be imposed on Iraq, which would have meant that the majority Shia would have controlled the country, as nominally, they do now...
That impasse was only breached when regardless of whether or not it was “signalled”, the mullahs got the idea that America would come in on Iraq’s side. And whether or not it was deliberate or not, which probably no-one will ever know, a turning point was when America downed an Iranian civilian airliner flying in Iranian air-space (and they still didn’t apologize). At that point the Iranians sensibly decided to call it a day,
The points I’m trying to reach are (a) is that you don’t need any “logic” to start a war, (b) most people who start wars are completely raving mad, (c) wars can have unintended consequences, (d) very often they achieve a spectacularly lousy return on investment (imagine if the $3 trillion had been spent upgrading public transport and public medical facilities in USA).
The message in the bottle is, don’t rule out a “Good-War”, in your retirement planning!!
Fast-forward to now, perhaps one of these days we will lucky enough get to find out how effective are the 3M82-SS-N-22 Sunburn Missiles that supposedly were the reason that Iran discontinued its nuclear program in 2003 (you don’t need nuclear as a deterrent if those things work as advertised).
The latest versions can apparently get through the defences on US battleships and Aircraft Carriers, and well oil-tankers…no problem, slice them in half!!
The new versions have the range to cover the whole of the “Persian-Gulf” (or Arabian Gulf – depending on who’s side you are on) from a 2,000 mile strip of land 50 miles deep along the Iranian coast, oh and that includes tankers docking on the new SPM’s in Fujairah that are designed to handle Abu Dhabi’s oil.
And one suspects that if the Saudi’s or anyone else says much more about “cutting off the head of the snake”, even in private, the “snake” might decide to use those Mothers to take out the electricity and desalinating capacity in Saudi, UAE and Qatar, before…of course….they get “bombed-back-to-the-Stone-Ages”, which seems to be the answer to every problem these days.
Doubtless the intelligence master-minds who gave us the bunkers in Tora Bora and WMD, are working out the risk-reward on that one, as we speak.
I don’t want to sound like a pessimist, but I have this sinking feeling that “third-time-lucky”, may not be the right-answer.
1: The price of oil will never-ever go down less than $75.
2: If Saudi is able to deliver on its promise to keep oil prices “Fair”, then while that lasts oil prices will go up broadly in line with the growth of world GDP in nominal dollar prices, if as is commonly believed, world oil production has peaked and it will “flat-line” for the next five to ten years.
3: If (or as soon as) Saudi is unable to deliver on that promise (or that becomes public knowledge), or if the flat-line starts to dip dramatically, then oil prices will start heading up towards the long-term replacement cost; long term as in the cost to get out the really expensive oil, which if gold is any guide is $138 in current (2010) prices.
4: If someone decides to start lobbing ordinance at Iran; and they decide to get “itsy” about that and decide to deploy their Sunburns, and they work, then there could be a period when the supply of oil to the world goes down at least 25%.
Based on the 1980’s bubble, when there was a 25% drop in production, that suggests a 25% reduction in consumption would lead to a 2x bubble in price (over the fundamental), plus a 33% increase in “fundamental” due to the drop in production.
Combined with perhaps a 10% drop in “real” world GDP (which would “mitigate” the rise in price, oil prices could go up to $90 x 2 x 1.33 x 0.9 = $215 in current (2010) prices. There would also be inflation averaging 10% over the next ten years (caused by oil-mispricing), which would bring oil prices up to $550 by 2020.
How long can the self-delusion last?
If Americans are starting to wonder just how delusional their government was over the past ten years (and not just in relation to oil prices and the disruptions that the tax to the blood-suckers has cost them), they can comfort themselves that the British Government, thanks in a large part to the efforts of a nasty little sociopath called Tony Blair, has been even more delusional.
You can look the whole story up on Wikipedia, but I remember in 1995 Dr. Colin Campbell made a presentation to the British Parliament explaining to them in words of one-syllable that oil would peak worldwide in 2007 (something that the IEA has conceded four years late (they say it was 2006)), and that there would be a dramatic increase in prices (then they were about $15).
No one listened; they just kept pumping out Scotland’s oil and selling it at a ridiculously low price, until it ran out. Short term political gain trumps long-term strategy every time, in democratic systems weighted towards lofty sound-bites, cheatable expense-account living and index-linked pensions for the “in-crowd”, and avoidance of pain today.
Part of the problem is the delusion that the problem will go away. There is no evidence that it will and there is a huge amount of evidence that it won’t.
There are plenty of things that governments with any interest in the long-term prospects of the people they represent and their children, can do, (well there is a theory that one or two give a toss).
The most obvious of which would be to guarantee the developers of marginal supplies, and marginal technology to increase efficiency and//or to find substitutes, a minimum price-equivalent equal to the “fundamental” price, as is defined by:
“FOOT” = “TOAD” multiplied by “3.33%”” divided by “OIK”
How crazy would that be!!
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( firstname.lastname@example.org ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2010 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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11 Dec 10, 01:40
Oil bottomed at $32 in 2009 not $46
Oil bottomed at $32 in 2009 not $46.
Why do the graphs show 46?