Today’s headlines covering the price of crude oil are as confusing as they can be. On Monday of this week, the financial press quoted a story in a competing publication, referencing an analyst from Citibank who expects the price of West Texas Intermediate (WTI) crude oil to top $60 per barrel before the end of this year; and prices went up. Then Tuesday, there is a story from an analyst representing Goldman Sachs who said he believes the price of WTI crude oil will fall below $40 per barrel by the end of this year; and prices went down first, then they settled up. If you’re like me, you gotta be asking yourself, what in the world is going on here? Market fundamentals, otherwise known as bits of information that affect the price of a commodity, can’t point in opposite directions at the same time; can they?
In my bookcase, next to my desk, I have several textbooks covering macroeconomics, microeconomics, statistics and price theory. These textbooks represent years of commitment to study the myriad of economic theories developed over the years. I have continued to study these principals for more than 30 years while working in the markets, and it has allowed me to gain a set of gut-instincts to better identify market anomalies like what we’re seeing today.
Macroeconomic influences affect prices all the time and on a more global scale, however, when the market begins to receive conflicting signals, like they are today, we must turn to microeconomics to determine the culprit and then utilize some very specialized tools to clear up the confusion.
The same principles apply with the production of crude oil. When conflicting signals arise, confusion erupts. This then sends mixed signals to investors, producers and consumers alike. In times like these, I have to look back into my textbooks to understand the micro-influences that are driving crude oil prices in this very tight range. Then we must employ these theories and grasp the behavior of these microeconomic inputs to make sense of all the conflicting signals. Believe it or not, the energy complex specifically in the production of crude oil, has a unique set of economic drivers and any one can conflict with another when you drill-down and look at the numbers.
Microeconomics vs Macroeconomics
For us to understand how competing predictions exist, we must understand that not all corporate analysts agree on the same microeconomic inputs to employ, even when they agree on the overall macroeconomic direction of a market.
In the crude oil world, microeconomics is, “the study of the decisions a corporation makes, regarding their allocation of resources, including both capital and natural resources.” Microeconomics relies heavily on supply and demand to help determine where to deploy those resources. With the “optimum” placement of resources comes price appreciation, especially when increasing demand drives the market. That’s obviously the goal in all markets: increasing profit! When oversupply drives the market, like we’re seeing today in crude oil inventories, prices fall and corporations reallocate their resources somewhere else, or sometimes just sit it out and keep their powder dry for another day. In other words, microeconomics provides a more finite look at a corporation’s decisions on their allocation of resources, and that is much more specific in nature. It’s much more difficult to drill-down too, because information may not be as readily available.
Macroeconomics on the other hand, “is the study of the behavior of a market as a whole, in other words, it looks at the broader market influencers like changes in Gross Domestic Product (GDP); changes in the U-6 Unemployment number; imports and exports and so on.” It’s much easier to make predictions on price direction using macroeconomic drivers, but they are not as finitely accurate. To put the microeconomic drivers into perspective, I developed a system to assist when working to identify price direction.
As an economist, I look daily at the micro and macroeconomic factors within the energy market to help find what I call a “pearl”. In my system, a pearl is a specific subset of numbers that, when coupled with other pearls, can send a signal to change the direction of a price within a market. When several pearls are identified, we have what I call a “set of pearls” and the more unique the pearl or metric, the more valuable that set of pearls become; just like the real thing. So, adding together pearls has value, but when a “unique pearl” is added, it increases the value even more. It makes sense.
One analyst might look at the effects of too much production in the US on the price of crude oil while another looks at the average amounts of Cap-X that Exploration and Production (E&P) companies are planning to spend. Both may represent significant values, but when they combine in the same direction, their value is enhanced. Then, when we add a “unique pearl” to the mix, like a major reduction in crude oil inventories, the overall value of this set is increased by the value of that unique pearl.
Very often, two or more “pearls” oppose each other, like we saw in Monday and Tuesday’s reports and they are not significantly impacting prices either way. Once we are able to string together a “set of pearls”, we will finally be able to impact the price of crude oil. That’s what we’re seeing right now with Citibank and Goldman Sachs; they are searching for a couple unique pearls to string together to change the direction of our prices, either higher or lower.
Using this concept, the ultimate prize in any market is to be the first to recognize a “set of pearls.” In other words, be the first to see two or more microeconomic metrics shift and move in the same direction. That’s where corporations make money, and so do traders. He who discovers this market phenomena first, benefits the most. That’s what the competing bank analysts are doing; trying to get ahead of a developing set!
Unfortunately, most readers never see how the “sausage is made”, so to speak. They don’t get to see the inner workings of price discovery, and it’s not an easy analysis to make, especially when information is difficult to gather in our industry. Let’s face it, the financial press would rather report on the conflict between competing large banks because competing banks are certainly much more newsworthy than trying to explain the conflict between competing microeconomic factors.
Here’s the bottom line, what I read into the Citibank analysis is the balance between supply and demand is swinging back into line. Programs like the Organization of the Petroleum Exporting Nations (OPEC) production reduction program and the US not increasing production at the rate it was in the beginning of the year tell the Citibank analyst we may see a shortage of crude oil production by the end of this year, thereby increasing prices to nearly $60 per barrel. It’s a stretch, but if correct, prices could soar.
What I read into the Goldman Sachs story is this, OPEC will probably not fulfill their commitment to reduce 1.2 million barrels of crude oil production from current levels through March of 2018, and the US shale producer will slowly but surely increase production to over 10 million barrels per day by this time next year. Many analysts believe—with the Libyans increasing crude oil production to record levels and the Saudis exporting more barrels of crude, if only to protect market share—prices will surely fall. Whatever the cause, prices are not responding to the OPEC production cuts. This tells us the current program isn’t working and if the US continues to increase WTI crude oil production, prices should indeed drop into a level below $40 per barrel.
While it seems we are working at cross purposes, we’re seeing competing microeconomic and macroeconomic factors that indicate there is very little consensus on the direction of the price of crude oil and the refined products. With each little inventory report or Baker Hughes Rig Count comes another “pearl”. The question is, when these “pearls” form a set, which direction will they point?
Read More from Crudefunders
- Who Is OPEC and Why Do We Care?
- OPEC Appears To Be Delivering On Production Cuts, So Why Aren’t Prices Rising?
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- Crude Oil Production & Supply: Have We Made Any Actual Progress in A Year?
- Innovators Make a Difference in Oil and Gas!
- Geopolitical Risk and Its Effect on the Price of Crude Oil
- What Can We Learn from Crude Oil’s First Quarter Report Card?
- Crude Oil: What is the Future
- How Crude Oil Prices React to Geopolitics
- Prices at the Pump Are Rising: Is It Seasonal or Something Else?
- Is Ethanol Worth the Fight?
- What Are OPEC and the Saudis Up To?
- Energy Independence: Why US Crude Oil and Natural Gas Matters
- Crude Oil and Market Psychology
- Crude Oil: A Technical Analysis
- Crude Oil: Technical Analysis II
- Crude Oil: What’s Really Dragging Prices Down
- The Real Culprit of Low Crude Prices: Oil Demand
- Is OPEC Imploding?
- Energy Independence Protects Our Nation
If you want more information on the energy markets and what is making prices move every day, go to our website www.crudefunders.com and scroll down to where it says “Subscribe”. There you will find our link to the daily commentary “Energy Wise”, a comprehensive piece that includes both fundamental and technical analysis of the day’s energy markets and provides you with the detail that you need. For more on Energy Economist Tim Snyder and his company, go to www.matadoreconomics.com.