Cees Bruggemans: With oil price, take the long view; five year futures at $73

Cees Bruggemans economist
Cees Bruggemans, SA’s leading independent economist

Life is difficult. Life is complex. And for many, this makes existence a turbulent roller coaster of one surprise after another. Being organised and disciplined helps. But the smoothest ride comes from seeing events in perspective. Cees Bruggemans has done this for us on the big story of 2014, the collapsing oil price. He draws on recent views expressed by Goldman Sachs’s Jim O’Neill to make his  point. Brilliant insights. – AH

By Cees Bruggemans  

The excellent point made about oil prospects by Jim O’Neill, former chief economist of Goldman Sachs and father of the BRICs acronym, is that in order to cut out short-term speculative noise, focus instead on the five-year forward futures contract.

Over time, he found such prices to have the best predictive value of what would eventually transpire.

Clearly, all those involved in the global oil business have to discount the likely trends in demand and supply over the intervening years. The condensed global understanding of the underlying realities ultimately translates into a price for future crude oil delivery five years hence.

So if you are interested in what the longer term marker is going to be, once we are past the short-term shake-out, what have we got?

Spot Brent may be $50 but the five-year forward contract is $73.

But that needs a minor adjustment to make it relevant to today. Discounting it by likely American inflation (we are talking Dollar terms in the global oil business) we get to a current value of about $65-67

What can we say about that $65-67 level, the distilled global oil wisdom of the moment?

As a longer term Brent oil marker, $65 in today’s prices and seen through to 2020 is a long way removed from the $110 average that prevailed from 2010 through mid-2014, shaping our lives.

It is about 40% less. That’s not nothing, even if it isn’t $50, never mind $30 or $20 (as hinted by the Saudi oil minister as possible short-term destinations as they squeeze the global production marginals).

I think most of us would be more than happy to sign for a $65-67 Brent oil price in today’s terms through at least 2020.

But it doesn’t stop there, as Jim probably would be the first to acknowledge.

For the distilled global wisdom isn’t a constant. It is a moving feast, as new data, and insight, is absorbed and comes to prevail, about underlying demand and supply realities and cost structures.

This distilled wisdom is traditionally not a fast mover, for oil is a sticky business, as much on the demand as the supply side.

But it does move. And as Jim has observed, it has been sliding ever so gently for some years now, well ahead of the sudden onset of the mid-2014 spot collapse.

In other words, the writing has been long on the wall, just slow in coming, with the acceleration in American fracking an important part of the equation, but so too the experiences of other producers inside and outside OPEC, the demand evolution in rich countries, the likely evolution of China and other EMs, and many more such perceptions and actual data, and finally given a shove down the stairs as the Saudis made their historic pivotal move.

One intriguing question, to which we don’t have an answer, except patiently waiting, is how the distilled wisdom of global players will still evolve over the coming years.

Will the shifting five-year forward contract get stuck at its present $73 level? Will it start rising? Will it slide some more, with the adjustment underway in recent years as yet incomplete, possibly far from finished?

What is it that has not yet been discounted in Brent oil futures prices that could still await us?

A greater global shakeout of production marginals than now foreseen (in which case price bounce back)? A much more determined Saudi focus on staying on top of its market share, undercutting marginals for longer and then ensuring a low enough marker to prevent many marginals of eventually returning, and creating disincentive for global oil efficiency technology and investment (in which case the price sliding isn’t over yet)?

And similar penetrating questions have to be asked about growth in various parts of the world, its composition, energy intensity, implied oil displacement and many more such questions.

And then beyond the economics there is the geopolitics, with certain attitudes heavily weighing in shaping monopolistic oil supplying and pricing behaviour (with global well-being in mind, narrower local interests, esoteric regional preoccupations, grand-slam geopolitical chess, or whatever)?

Where do I think the marker price will settle?

To me the underlying realities aren’t finished shifting. Just as in the 1960s they had an upward bias price logic, today I am inclined to explore the downside some more. The Brent spot price today does not figure in such thinking, as it has far too much squeeze built into its make-up, as much Saudi intentions (never of the simple variety) as momentum speculation płays (always simplicity itself).

But beyond the noise our oil world is being transformed. By Jim’s reckoning we are already down to $73 on a five year view, to me translating that to $65-67 real today.

That is already a wonderful windfall gift to absorb through 2020 at least if it stands.

But I sense that the evolving underlying adjustments have not yet divulged their full future maturity to us, even if it won’t be as rich as the spot speculations would have us believe.

But then I will sign up any day for a halving in the real oil price through 2020 compared to the gouging of recent years.

Reference: Jim O’Neill “How to crack the oil price conundrum” Business Day 5 January 2015

 * Cees Bruggemans is the Consulting Economist at Bruggemans & Associates (www.bruggemans.co.za). Email him at  [email protected]