Mega-Bear versus Super-Spike

Update: Never say never. Today, the prediction I made in 2005 that WTI would never again fall below $50 has fallen. Front month WTI as of this writing has dipped to $49.75. But it will never fall below $40.

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In 2005, with oil trading in the $40′s and $50′s, Goldman Sachs raised some eyebrows when they predicted that we could soon be looking at a ‘super-spike’ and oil prices going as high as $105. As this scenario played out this year, the analyst who made that call – Arjun Murti – raised the ante and said that we could soon see oil at $200. The New York Times, in an article in which they dubbed him an ‘oracle of oil’, reported:

An Oracle of Oil Predicts $200-a-Barrel Crude

Arjun N. Murti remembers the pain of the oil shocks of the 1970s. But he is bracing for something far worse now: He foresees a “super spike” — a price surge that will soon drive crude oil to $200 a barrel.

Mr. Murti, 39, argues that the world’s seemingly unquenchable thirst for oil means prices will keep rising from here and stay above $100 into 2011. Others disagree, arguing that prices could abruptly tumble if speculators in the market rush for the exits.

There are some things to be said about predictions. If a person makes enough predictions, they are going to miss some – no matter how well they know their subject matter. On the other hand, when many people are making predictions, some will inevitably get it right for the wrong reasons.

Today I spotted a story in CNN that contrasted Mr. Murti’s prediction with that of Paul Sankey at Deutsche Bank:

Deutsche Bank ‘Mega-Bear’ Stomps Goldman’s Oil ‘Super-Spike’

I have a lot of respect for Paul Sankey. In my opinion he is very knowledgeable about the fundamentals of the oil markets. I commented on his 2007 testimony to the Senate Committee on Energy and Natural Resources on oil prices previously here. So where does Sankey think things are headed?

NEW YORK -(Dow Jones)- Oil prices could fall as low as $40 a barrel next spring as an overhang of new, efficient refineries come on line, an analyst at Deutsche Bank said Wednesday.

Calling it the “mega-bear” case for oil, analyst Paul Sankey said the combination of weak demand for gasoline and other products, coupled with the start-up of 2 million barrels a day of processing capacity at a new generation of refineries in India and China and expansion projects in the U.S. will combine to depress oil prices.

Sankey’s stance, while pessimistic, still anticipates slightly higher oil prices than the bank’s commodities analysts, who on Friday said that oil futures prices could fall further to $30 a barrel under their worst-case scenario.

While I don’t discount that Sankey could be right, I don’t think his reasoning in this case is sound. Added refining capacity does nothing to help add new crude supplies. New refinery capacity would primarily put downward pressure on gasoline and diesel prices. Of course if the added capacity is designed to primarily handle cheaper crudes that are heavier and more sour, then it would lessen demand for light, sweet crude and Sankey’s scenario could come to pass.

In some cases, those who get it right can be spectacularly wrong on their reasoning and may not really understand much about the fundamentals. I am not suggesting that Mr. Sankey or Mr. Murti fall into that category, but I have run across speculators who cited their conviction that Saudi production was on a steep decline as the reason they were betting on higher prices. For a while, it was difficult to argue with these people, as they could simply point to the oil price as vindication. In the short run, smart people can get it wrong and uninformed people can get it right. But those anomalies will tend to correct themselves in the long run.

Personally, I predicted in May of 2005 that we would never see oil prices drop below $50 again. While I have been correct for the past 3.5 years, when I checked prices last night after touching down from Europe I saw that I am coming increasingly close to being wrong on that account. Oil is now trading at $52 and change, so my prediction could be falsified any day now.

For me, the important thing is to understand why that prediction is on the verge of being falsified. Have I been one of the lucky who was right, but for the wrong reason? What I foresaw was continued tightening demand that kept upward pressure on oil prices. What actually happened played out like that at first, but then we saw a huge spike that ultimately crushed demand. I think without this summer’s huge spike that today we would be trading in the $70′s or $80′s as demand continued to creep ahead. So I think that even though my prediction may be falsified, the reasoning behind it is still sound.

In the long run, I still see the same thing. I believe we will revisit $100 oil within a couple of years (in my ‘steady growth’ model, I foresaw us first cracking $100 in 2009). While there will be great volatility as we are seeing now, I don’t believe we will return to years of oil prices at this level. I think that we are bottoming out, and 20 years from now we will see a whip-saw on the graph for 2008, but we will continue the same upward trend that has been in place since 2002.