Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21
Why Tether USDT, Stable Scam Coins Could COLLAPSE the Crypto Markets - Black Swan 2021 - 6th Jun 21
Stock Market: 4 Tips for Investing in Gold - 6th Jun 21
Apple (AAPL) Summer Correction Stock Trend Analysis - 5th Jun 21
Stock Market Sentiment Speaks: I 'Believe' We Rally Into A June Swoon - 5th Jun 21
Stock Market Russell 2000 After Reaching A Trend Channel High Flags Out - 5th Jun 21
Money Is Cheap, Own Gold - 5th Jun 21
Bitcoin and Ravencoin Cryptos CRASH Bear Market Buying Levels Price Targets - 4th Jun 21
Scan Computers - How to Test New Systems CPU, GPU and Hard Drive Stability With Free Software - 4th Jun 21
Hedge Funds Getting Bullish on Gold - 4th Jun 21
THERE ARE NO SOLUTIONS When the Media is the VIRUS - 4th Jun 21
Investors Who Blindly Trust the ‘Experts’ Will Get Left Behind - 4th Jun 21
US Stock Market Indexes Consolidate Into Flagging Pattern – Watch For Aggressive Trending Soon - 4th Jun 21
Microsoft (MSFT) Stock Trend Analysis - 3rd Jun 21
No More Market Bloodbath – Beyond Cryptos - 3rd Jun 21
Bank run, or run from the banks? - 3rd Jun 21
This Chart Shows When Gold Stocks Will Explode - 3rd Jun 21
The Meaning Behind Gold’s Triple Top - 2nd Jun 21
Stock Market Breakout Or Breakdown – What Does The Next Big Trend Look Like? - 2nd Jun 21
Biden’s Alternate Inflation Universe - 2nd Jun 21
What You Should Know Before Buying Car Insurance - 2nd Jun 21
Amazon (AMZN) Stock Summer Prime Day Discount Sale - 1st Jun 21
Gold Investor's Survival Guide - 1st Jun 21
Silver and Copper to Benefit from Global Electrification Push - 1st Jun 21
Will Gold Shine Under Bidenomics? - 1st Jun 21
Stock Market Buy the Dip, Again?! - 1st Jun 21
Stock Market Consolidation Ahead - 1st Jun 21
Stock Market Summer Correction Review, Crypto CRASH, Bitcoin Bear Market Initial Targets - 31st May 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

On the Price of Oil

Commodities / Crude Oil Jun 02, 2016 - 07:04 PM GMT

By: Steve_H_Hanke

Commodities Since its high of almost $108/bbl in June of 2014, we have witnessed a stunning collapse in the price of oil. Indeed, in February 2016, a barrel of West Texas Intermediate (WTI) was trading at $26/bbl, a 76 percent plunge from the June 2014 highs. It has since clawed its way back to $49/bbl (May 24th).



What caused the price collapse of this all-important commodity, and where is its price headed? When looking for the causes of price change, nothing beats a sound supply-demand analysis. In the past few years, the United States has played a big role in affecting the world’s oil supply picture. The U.S. was once the world’s largest producer and exporter of oil, and by 1970, its production peaked at 9.6 million barrels per day. Then, a long decline set in, and by 2008, U.S. oil production had been slashed to 50 percent of its peak.



Two new technologies – hydraulic fracturing and horizontal drilling – turned oil and gas production in the U.S. around dramatically in a few short years. By the start of 2015, oil production in the U.S. was 80 percent higher than it had been in 2008. The increase of 4.1 million barrels per day exceeded the comparable increase in every OPEC country but Saudi Arabia.

So, there was a supply surge led by the U.S. In addition, the world was mired in slow growth following the financial crisis of 2008-09. The supply-demand factors finally caught up with the oil market in June 2014, when the market started to roll over. By the time of the 166th OPEC meeting in November 2014, the price of a barrel of WTI had fallen from $108/bbl to $74/bbl, a 31.5 percent plunge. Then, a historic decision was announced at the meeting. In what became known as a “battle for market share,” the members of OPEC stated that they would allow market forces to determine oil prices. On that announcement, oil prices shed another 8 percent in one day.

Since that historic November 2014 OPEC meeting, there has been a great deal of shadow boxing among producers and an endless stream of forecasts about the future course of oil prices. One move that merits particular attention is that of Prince Mohammed bin Salman of Saudi Arabia. With Prince Mohammed’s Vision 2030 plan, it looks like the battle for market share will be the law of the land for the foreseeable future.

To understand the economics behind the Saudi production increase in their quest to maintain market share, we must understand the forces that might cause the Saudis to increase their discount rates.

When it comes to the political instability in the Middle East, the popular view is that increased tensions in the region will reduce oil production. However, economic analysis suggests that political instability and tensions (read: less certain property rights) will work to increase discount rates, which will increase oil production.

Let’s suppose that the real risk-adjusted rate of discount for the Saudis, without any prospect of property expropriation, is 20 percent. Now, consider what would happen to the discount rate if there were a 50-50 chance that a belligerent will overthrow the House of Saud within the next 10 years. In this case, there would be a 6.7 percent chance of an overthrow in any given year. This risk to the Saudis would cause them to compute a new real risk-adjusted rate of discount, with the prospect of having their oil reserves expropriated. In this example, the relevant discount rate would increase to 28.6 percent from 20 percent. This discount rate increase would cause the present value of reserves to decrease dramatically. For example, the present value of $1 in 10 years at 20 percent is $0.16, while it is worth only $0.08 at 28.6 percent. The reduction in the present value of reserves will make increased current production more attractive.

So, the Saudi princes are panicked and pumping oil today – a ‘take the money and run’ strategy – because they know the oil reserves might not be theirs tomorrow. In short, problematic property rights encourage rapid exploitation.

This sets the stage for what is the big question on everyone’s mind: where is the price of oil going from here? To answer that question, we have to have a model – a way of thinking about the problem. In this case, a starting point is Roy W. Jastram’s classic study, The Golden Constant: The English and American Experience 1560-2007. In that work, Jastram finds that gold maintains its purchasing power over long periods of time, with the prices of other commodities adapting to the price of gold. Taking the broad lead from Jastram, my colleague, David Ranson, produced a study in April 2015 in which he used the price of gold as a long-term benchmark for the price of oil. The idea being that, if the price of oil changes dramatically, the oil-gold price ratio will change and move away from its long-term value. Forces will then be set in motion to move supply and demand so that the price of oil changes and the long-term oil-gold price ratio is reestablished. This is nothing more than a reversion to the mean.

We begin our analysis of the current situation by calculating the oil-gold price ratios for each month. For example, as of May 24th, oil was trading at $49.24/bbl and gold was at $1231.10/oz. So, the oil-gold price ratio was 0.040. In June 2014, oil was at $107.26/bbl and gold was at $1314.82/oz, yielding an oil-gold price ratio of 0.082. The ratios for two separate periods are represented in the accompanying histogram – one starting in 1946 and another in 1973 (the post-Bretton Woods period).

Two things stand out in the histogram: the recent oil price collapse was extreme – the February 2016 oil-gold price ratio is way to the left of the distribution, with less than one percent of the distribution to its left. The second observation is that the ratio is slowly reverting to the mean, with a May 2016 ratio approaching 0.04.

But, how long will it take for the ratio to mean revert? My calculations (based on post-1973 data) are that a 50 percent reversion of the ratio will occur in 13.7 months. This translates into a price per barrel of WTI of $60 by March 2017. It is worth nothing that, like Jastram, I find that oil prices have reverted to the long-run price of gold, rather than the price of gold reverting to that of oil. So, the oil-gold price ratio reverts to its mean via changes in the price of oil.

The accompanying chart shows the price projection based on the oil-gold price ratio model. It also shows the historical course of prices. They are doing just what the golden constant predicts: oil prices are moving up.

The report that motivated this line of inquiry is: R. David Ranson. “Tactical Asset Selection: Implications of Cheap Crude Oil for Its Future Price Trajectory,” Cambria, California: HCWE Worldwide Economics, April 17, 2015.


I would also like to acknowledge excellent research by the following research assistants at The Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise: Stephen Johannesson, Pranay Orugunta, Anshul Subramanya, and Jennifer Zheng.

By Steve H. Hanke

www.cato.org/people/hanke.html

Twitter: @Steve_Hanke

Steve H. Hanke is a Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore. Prof. Hanke is also a Senior Fellow at the Cato Institute in Washington, D.C.; a Distinguished Professor at the Universitas Pelita Harapan in Jakarta, Indonesia; a Senior Advisor at the Renmin University of China’s International Monetary Research Institute in Beijing; a Special Counselor to the Center for Financial Stability in New York; a member of the National Bank of Kuwait’s International Advisory Board (chaired by Sir John Major); a member of the Financial Advisory Council of the United Arab Emirates; and a contributing editor at Globe Asia Magazine.

Copyright © 2016 Steve H. Hanke - 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.

Steve H. Hanke Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in