Oil Price Will Continue to Rise Long-Term. Our Advice: Buy the Dips

On Friday, oil prices continued their downward movement. With two large finds announced this week, resumption of service at BP’s Prudhoe Bay pipeline, and the end of the summer driving/air conditioning season the commodity is taking a bit of a breather. Already down on the notion that a global economic slowdown would curtail demand, the latest knocks have broken important technical resistance levels (see chart for oil ETF below.) Is the commodity bull run now officially over?

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We don’t think so. We aren’t believers in oil for seasonal reasons, or on the basis of supply disruptions, or even for technical reasons. We believe oil will continue to rise because capacity is nearly fully utilized, demand will continue to rise (even if interrupted briefly by an economic slowdown) and because it is hard to find and utilize new energy sources, whether they be new oil reserves, oil sands or even alternative energies. These sources will not replace five percent of world demand overnight, but with global demand rising at roughly five percent every year that is what would be needed to get oil prices down for an extended period.

Maybe it’s just a function of T Theory, which states that a bull run will last as long as the preceding “rest” period - in this case oil has had a 20+ year rest period, so the bull run should still have legs if the theory holds. Or maybe it’s an Elliot Wave type of event. Or perhaps it falls on behavioral patterns - the long period of low oil prices led to underinvestment that will not be reversed for a long period of time. Whatever theory you want to point to for explanation, we just think oil will generally go up for the foreseeable future.

The action last week was starting to get nonsensical. Take Conoco Phillips (COP) for example. On Friday they announced a major gas find in the North Sea adjacent to one they are already exploiting. However, the shares fell nearly 2%. It’s not like the new find will be the straw that breaks the oil camel’s back and floods the world with supply. It will take years to exploit the find and it will barely affect total energy supply when it is up and running. But for Conoco it has a more meaningful impact, and not the type that should send the shares down.

As to the rise in inventory, there was one. For total crude products, there are now 50.4 days of supply, up from 50.0 days last week (see chart.) We are even flirting with the long-term downtrend line again, potentially signaling that we are wrong and that the world (or at least the US) truly is awash in oil (the two gas stations we tried today, both being out of regular gas, tell another story). But we are also still 10% below the average inventory level of the last 15 years, and well below the levels in 1990.

During the stock market run of the 1980’s and 1990’s the common advice was to buy the dips. During the commodity run of the 2000’s and 2010’s, that is our advice for investors in oil.

Comments

[WC Whiner]

Yeah, I'm unconvinced. Cf my post in response to your last note on days inventories. Short story shorter: days inventories were in a long downtrend from the beginning of the data I can find ~1980 through about 2005, during which we saw two very different crude-market regimes. The idea that inventory trends speak to anything in the long term is contradicted by the data.

As I say, in the short term, they matter. In the long term, not so much. Then again, in the long term, you were long oil in 1981. How'd that work out for you?

[WilliamTrent]

There is no doubt that businesses have tried to become more efficient in the last 20 years, and not carrying excess inventory is a part of that. Ask Ford if high days of inventories is a good thing. We agree that days inventory have not been a predictor of prices over the last 20 years. We do contend, however, that looking at total supply in barrels (rather than days of supply) as some of the bears were doing is an incorrect metric for considering supply/demand balance.

Our belief is that the long-term trend of shrinking inventories was due to the fact that holding oil during that time was a money-losing proposition. As oil prices fell producers, wholesalers and retailers were more willing to hold less inventory, as holding the inventory presented both storage costs and the potential that prices would decline further. For the same reason, companies also underinvested in finding new sources - whether they be new oil fields or alternative sources - there was no business incentive to do so.

Meanwhile, demand continued its steady upward march. The last five years have been the wake-up call, saying "Hey, you need some new energy capacity." Now higher prices are starting to provide the business incentive but it will take years for the new supplies to make it to market. Eventually they will, and when they do they will come in large numbers just as consumers have started switching en masse to more energy-efficient products and prices will plummet for 20 years. That's the way the free market tends to work in the commodities business.

But in the meantime - we expect higher prices.