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February 11, 2015

Where Is The Bottom for Oil Price?

By Lance Roberts at Street Talk Live
The plunge in crude oil prices has certainly taken "center stage" as of late and a day doesn't pass that a conversation is not had about the future of oil prices and subsequently oil-related investments. Is the decline in oil prices over? Have oil related investments put in a long-term bottom and now provide investors with a "once in a generation" investment opportunity?  Maybe.
However, the truth is that I don't know. In fact, no one does. I live in Houston where the economy virtually lives and dies by the price of crude oil. I am inundated daily with emails from "people in the oil patch" that swear the bottom is in and that they "know" prices are going to rise back to previous levels and even higher. Again, maybe. However, there is plenty of evidence, as shown in the first chart below, that not only can oil prices fall a great distance, they can stay low for a very long period of time.
Oil-Prices-InflationAdj-021015
Maybe the experts in the oil industry are correct? Maybe this is like the 2008 event where oil prices plunge and then come surging back? It is possible, but it is worth noting that the vast majority of the run-up post the financial crisis was directly related to the ongoing Federal Reserve interventions. It is quite likely that oil prices were elevated well beyond their underlying fundamentals.
Oil-QE-021015
However, given that the Federal Reserve is no longer intervening, and potentially looking to tighten monetary policy further by raising interest rates, that tailwind has now become a potential headwind.
One argument against the "bottom" of oil prices being "in" is that oil supplies are still rising while global demand remains weak due to global deflationary pressures. That trend shows little signs of slowing at the moment.
Oil-Supplies-021015
But, in the short-term there is little argument that oil prices have become exceptionally oversold. The chart below shows oil prices against 2-, 3- and 4-standard deviations of the 4-year moving mean. (Oil prices at 4-standard deviations is a very rare event.)
Oil-Stddev-4yrAvg-021015
The bounce back in oil prices over the next twelve months could theoretically be quite significant pushing levels in the high-70's. Such an event will likely suck many investors back into the oil complex believing that the "crash" is over. However, there are two important aspects to consider.
First, potential dynamics behind the drive higher in oil prices, including the Federal Reserve interventions, have changed. The global deflationary pressures continue to apply downward pressures on economies and energy based demand. Secondly, the surge in oil prices, supported by the Federal Reserve's monetary interventions, was likely an "echo boom" following the 2008 plunge in prices. That rise in oil prices likely lasted far longer than it should have, and now the completion of the long-term price correction is in process.
This idea suggests that a new range in oil prices will take hold that will fit more closely with actual underlying supply/demand dynamics. Before you completely dismiss this suggestion, take a look at the 3-month net change in oil prices and rig counts as shown below. Since the financial crisis took hold the "trend" in oil prices and rig counts has been trending lower. It is quite likely that rig counts have not seen their ultimate bottom as of yet, but an eventual equalization will likely occur with oil prices trading in a lower range than seen previously.
Oil-3mo-NetChg-021015
A potential lower range in oil prices also suggests that energy-related investments may also trade at potentially lower levels due to reductions in profitability.  The chart below shows energy related company prices (using XLE and XOP as proxies) as compared to the rig counts and oil prices.
Oil-XLE-XOP-Rigs-021015
There is little argument that both oil and energy asset prices are extremely oversold and due for a rather sharp corrective bounce. This is shown by looking at the 24-month rate of change in oil prices which are currently at their historic low point. (One interesting point is that historically 100% moves in oil prices have resulted in recessions. While that didn't occur due to the Federal Reserve's monetary interventions, the damage to the underlying economy has likely been done.)
Oil-24ROC-021015
That oversold extreme in oil prices most likely sets energy related assets prices up for a rather substantial "rebound" which could take asset prices back to their respective long-term means. However, such a retracement will likely be only a trading opportunity initially as investors "trapped" in losing trades head for the exits. The subsequent decline, and bottom, will likely provide a longer term investment opportunity. 
Oil-NYE-XOP-XLE-021015
No one knows for sure whether oil prices have bottomed. Forecasters have been repeatedly wrong for the last 20-years expecting substantially higher or lower oil prices than what actually occurred (remember "peak oil.") However, there are plenty of technical indications that suggest a trading opportunity could be at hand. But with valuations in the energy space exploding due to falling revenue and profitability, there is likely a good bit of"shaking out" left before this reversion is complete. (Also be careful of highly indebted oil related investments, there will likely be more liquidations than acquisitions in the not so distant future.)
Ultimately, the real question will be rather we have witnessed the peak of historically high levels in oil prices and are beginning a new long-term trend at lower prices as witnessed during the 80-90's? The ongoing decline in world demand, particularly given China's economic woes, is a new dynamic that likely hasn't been sufficiently included in many forecasts.
As with all things, recency bias (expecting the recent past to repeat in the future) tends to lead investors astray in making investment bets way too early. So, some caution is advised.
My suspicion is that we may see a very tradeable bounce in the near future. But the technical damage done to asset prices and a realignment of supply/demand dynamics will likely lead to another decline and bottoming process. Such an event would flush out the majority of speculative investors and allow valuations to realign which would provide the foundation for a long-term investment opportunity.
But, that is just my opinion.
Courtesy Lance Roberts at StreetTalkLive.com (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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