Thursday, January 7, 2016

Oil is extremely cheap

Arab Light oil fell to $27/bbl today, even as gold rose to $1108/oz. In terms of gold, oil has only rarely been this cheap.


The chart above shows the ratio of gold prices to oil prices. Today, one ounce of gold buys you almost 40 barrels of oil. That's only happened twice in the past 45 years (July '73 and July '86). In both instances, oil quickly rebounded.


The chart above shows that, in relation to other things (using the CPI as a proxy for the price of "other things"), oil is still above its all-time lows, but it is back to the levels that prevailed during the late 1980s and early 1990s, and it has fallen by a staggering 79% from its 2011 highs. This is the biggest percentage decline in oil prices to ever happen in the space of 14 months.


OPEC is refusing to cut back its oil production in order to preserve its market share, but U.S. producers have responded aggressively to collapsing prices. As the chart above shows, the active oil drilling rig count in the U.S. has plunged by two-thirds in the past 14 months. This implies a significant reduction in expected oil supplies, at the same time as consumers have responded by driving more (vehicle miles driven in the most recent 12 months are up 3.5% over year-ago levels, the first increase in 9 years). I think it's safe to say that it won't be long before oil prices rebound.

Oil prices are sending a powerful message to producers and consumers: produce less and consume more. Markets sometimes take awhile to fully respond to dramatic changes in prices, but they don't take forever.

13 comments:

Benjamin Cole said...

IMHO another great post. Might be time to think oil stocks.

Side note: long term there may be a ceiling on oil prices. There are tremendous advancements being made in batteries and in the production of alternative fuels. Little noticed, demand for oil in the developed world has been falling for decades.

Far from Peak Oil, we may be entering the world of Peak Demand.

marcusbalbus said...

offer some calls or puts backing up your opinion and i'd find this mildly less inane.

Clinton Condo said...

Thank you.

What if gold ends up being on the expensive side of the equation? Oil may remain at low prices. Interest rates rising may put downward pressure on gold and a cap on oil.

marcusbalbus said...

false signal read by grannis, just as his read on swap spreads is.

randy said...

This is a very fascinating story. One thing is certain, there will be a lot of winners and losers in this trade. At some point, maybe now, is the right time... tempting. Still, I think Benjamin makes an important point. There are a lot of technological and social headwinds to oil demand. Fuel efficiency standards, younger people choosing not to have cars and being unwilling to have long commutes for work, Uber, self driving (hybrid/electric) cars, etc. Offsets are growing demand in developing countries. Old Gray Eyes once discussed how he was a trader - but usually with secular trends on his side for the trade. Oil doesn't seem to have a good secular trend.

I do appreciate and value Scott's interpretation of prices - what the hell do I know.

Scott Grannis said...

Re gold. I have been calling for gold to move lower for years, and I expect that trend will continue, as crude oil moves back up. So the ratio of gold to oil should move down with help from both the nominator and denominator.

Kenneth said...

Scott,
Why do you feel that the ratio of gold to oil is a meaningful indicator that oil is very cheap at current levels? In other words why isn't this one of those "correlations" that has no cause and effect relationship?

Roy said...

"Oil prices are sending a powerful message to producers and consumers: produce less and consume more. Markets sometimes take awhile to fully respond to dramatic changes in prices, but they don't take forever."

Right. But is that "time" one year or three years? Makes a world of a difference. Those OPEC countries are not exactly rational entities. Who says they will not continue in the downward spiral for as long as they can, and beyond?

I think a safer bet would be to try and calculate when would rents stop rising so much compared to income so U.S. households can start spending those savings on consumption other than rents. Now THAT would be big and perhaps the day where Scott's inflation prediction would come true.

Scott Grannis said...



Supply siders have long believed that gold has monetary properties, and that measuring things in terms of gold may yield more information than measuring those same things in terms of currencies. A rise in gold prices relative to dollars, for example, may be the market's way of discounting an expected devaluation of the dollar in the future.

This is not a scientific approach, to be sure, but I think it is something to consider in addition to other information. I note that oil prices have suffered an unprecedented decline apparently in response to an unprecedented increase in U.S. production, thanks to new technologies. Extreme changes in prices often evoke significant responses from market participants that tend to limit or reverse those price changes.

Cabodog said...

Scott, interested in hearing your thoughts on another commodity: Dr. Copper. Not doing so well; what is it telling us?

William McKibbin said...

Watch for oil to drop below $20, gold below $700, and silver below $5 -- China is shedding over-valued dollars to acquire dirt cheap commodities -- the only losers in China will be the people, who will endure a declining standard of living -- the losers in the US will be anyone holding stocks, bonds, bills, notes, etc.

William McKibbin said...

PS: Investors beware...

Scott Grannis said...

Cabodog: The dollar explains a good deal of the action in the commodity pits (e.g., stronger dollar, weaker commodity prices). Over the past 5 years, the correlation between the dollar and copper prices has been -0.61. Ditto for the CRB Raw Industrials, with a 5-yr correlation of -0.51. Ditto for crude oil, with a correlation of -0.57.

I note, however, that the dollar has been in a relatively flat trend for most of the past year (its value today vis a vis other major currencies is equal to its value in early March '15), even as commodities have continued to decline. I suspect that the recent relative stability of the dollar portends some firming in commodity prices. In that regard I note that the CRB Raw Industrials index is up almost 4% from its recent multi-year lows, and is back to the levels of early November. It's probably premature to call a bottom in commodities, but the action is nonetheless encouraging for commodities, assuming no further dollar strength.