Expect Oil to Rebound

Expect Oil to Rebound

Right now, I am incredibly uncomfortable.

I’ve set up shop in a tyre repair service centre. It seems my car found a stray nail on the road yesterday. Today, I woke up to a half-inflated tyre.

So here I sit, in the front of a tyre repair shop, on a couch made for humans much smaller than I.

Adding insult to injury, I am opposite a petrol station. The current price is $1.19 per litre. There’s a line of cars leading to the road.

I know why.

Eight days ago, I paid $1.36 per litre for 100 litres of petrol. And given that prices were as high as $1.69 three weeks ago, I honestly thought I had a bargain.

But no. It appears the bigger falls in oil prices had not yet filtered through to Australia.

However, according to Jim Rickards, the fall in oil may not last long. Today, he outlines the three indicators he uses when it comes to forecasting oil prices. And the price change may all hinge on the smallest of geopolitical events playing out.

Now, it’s over to Jim.

And I’ll continue to sit here and sulk about the very expensive 65 remaining litres of petrol in my tank.

Best wishes,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia

Expect Oil to Rebound

Jim Rickards, Strategist

Jim Rickards

My model for forecasting oil prices has three top-level factors represented graphically by arrows pointing up, down or sideways.

An up arrow is coloured green and points to higher oil prices.

A down arrow is coloured red and points to lower oil prices.

The sideways arrow is coloured grey and suggests that the relevant factor is neutral with respect to oil prices.

Of course, there are innumerable subfactors behind each of the main factors that form a lattice of cause and effect and that lend themselves to inferential methods.

Still, the top-level ‘three arrows’ predictive analytic model has served me well when it comes to oil prices.

But this doesn’t complete the picture. There are two other critical analyses I use.

Economics 101 – supply and demand

The first factor is basic supply and demand.

If global economies are growing strongly or if supply channels are jammed or restricted in any way, that arrow will be green, indicating higher prices.

Conversely, in a global slowdown or a situation in which Russia, Saudi Arabia and the US have their taps wide open, the arrow will be red, pointing toward lower prices.

The second factor is inflation/deflation, which can influence oil prices independent of growth.

It’s entirely possible to have inflation in a recession (called ‘stagflation’) or to have deflation in a growth phase.

Japan has experienced this since the 1990s, and the US has had growth with disinflation at times from 2009–2017.

Inflation/deflation respond to real interest rates, capital flows and exchange rates. Inflation is a green arrow and deflation (or strong disinflation) is red.

The third factor is geopolitics.

Geopolitics can sway the oil price

Any credible threat to close the Strait of Hormuz or attack oil production or shipment facilities will produce a green arrow pointing to higher prices.

Economic sanctions, a form of financial warfare, will also produce a green arrow.

Likewise, cooperation and peace among major oil-producing nations — or at least the absence of hostilities — will produce a grey (neutral) or red (lower) arrow with respect to oil prices.

The geopolitical factor has to be treated carefully.

Most analysts assume that a war among oil-producing nations is automatically a cause of higher oil prices.

That’s not true unless oil facilities are directly targeted.

A war among oil suppliers actually results in higher output, not lower, as the warring powers are desperate to earn cash to fight the war.

The best example of this was the Iran-Iraq War of 1980–1988.

From 1 September 1983 to 1 February 1986, during the height of the war, oil prices plunged 67% from over US$30 per barrel to US$10 per barrel as both Iran and Iraq pumped oil furiously to earn hard currency to sustain their war efforts.

Oil prices do spike when war is threatened but tend to fall once the war begins.

Forecasting oil prices using this model is most difficult when the factors are sending mixed signals.

For example, the model today shows that global growth is slowing, which puts downward pressure on prices.

But Russia and Saudi Arabia, two of the world’s ‘Big Three’ oil producers (along with the US), are considering cutting output, and Saudi Arabia is reducing oil shipments to the US.

These tactics push the price of oil higher.

Ready for the oil bounce?

The inflation/deflation indicators and geopolitical metrics are also putting out mixed signals.

Oil and gold are two commodities that can properly be regarded as money or money substitutes in global currency markets.

With this complex data landscape, what is the outlook for oil prices in the months ahead?

The single most important factor in the analysis for oil is the supply/demand factor.

Global growth is slowing, which normally presages lower oil prices.

In an extreme case, a global recession or financial panic would result in lower prices.

But the growth slowdown is not yet at that stage. Even if demand for oil flattens, Saudi Arabia can single-handedly boost the price simply by cutting its output.

That’s what is happening.

Saudi Arabia has cut oil exports to the US.

This forces the US to use more of its own oil and forces a reduction in US inventories, which are followed closely by analysts and traders. The result is higher oil prices as supply in the US shrinks.

This manoeuvre by Saudi Arabia is partly in retaliation for a tactic used by Trump earlier this year.

Trump wanted lower oil prices ahead of the US elections. He also threatened severe sanctions on Iranian oil exports.

Saudi Arabia helped the US by increasing their oil output to make up for potential Iranian shortfalls and to help moderate price increases prior to the US midterms.

The result was a severe crash in oil prices visible in the chart below:

Oil Prices in Dollars Per Barrel (Right Scale):

Chart 1

Source: Thomson Reuters Eikon

Trump enjoyed the lower oil prices but did not hold up his end of the deal when it came to Iran.

The Trump administration granted sanctions relief to all of Iran’s major oil customers including India, China and Japan. The US got low oil prices and Iran got relief from sanctions.

The only loser was Saudi Arabia, which bore the brunt of lower prices.

Now, it’s Saudi Arabia’s turn to get even by reducing supply and driving prices higher.

Saudi Arabia out for revenge?

My inflation/deflation factor is neutral at the moment.

There is certainly fear of inflation among central bankers wedded to flawed Phillips curve analysis, but the evidence for actual inflation is almost non-existent.

A disinflationary trend is just as likely based on Fed overtightening through a combined policy of rate hikes and money burning called ‘quantitative tightening.’

The geopolitical factor is also neutral.

There is potential for a huge geopolitical flare-up if the Iran sanctions are tightened over the course of 2019 and 2020.

A geopolitical shock in the Persian Gulf could send it back to US$100. With Trump having backed out of the Iranian nuclear deal this spring, that possibility remains.

But for the moment, the situation is tense but calm.

With geopolitics and inflation/deflation both stuck in neutral and the supply/demand factor pointing to higher prices as the Saudis reduce supply, the net of the ‘three arrows’ is higher oil prices in the near future.

Rising US dollar inflation could also take prices higher.

Any evidence of actual inflation or a sudden increase in tensions with Iran could cause the upward price of oil to skyrocket from here.

All the best,

Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia