When will Oil bottom? I guess when economic rational decisions lead to economic rational outcomes!

So far, Saudi Arabia, Iran, and Iraq seem to be the only producers making economic rational decisions: they continue to raise production because price remains well over their marginal cost of production. But even within this rationality, there is irrationality: by all means don’t cut production, but why raise production, when it is not required – all it is doing is going into inventory and making a bad situation worse. For heaven’s sake, they could sell less Oil for more money simply by matching production with consumption. To be fair, they had act to force an answer to the question of who could produce at what price.

But then why should they? After all we have Angola, Nigeria, Equatorial Guinea, Brazil, and Russia amongst others who could cut. Prices are almost certainly well below their marginal cost of production from deep-water and harsh environment wells. They don’t cut, because nations don’t always respond to the profit motive until they have no choice. 

In the United States too, there is much production well underwater. But we are only just beginning to see cuts work their way through the system.In the early months of the Oil price crisis, there would have been significant sunk costs, and so continuing to produce below marginal costs might have made sense -  because revenue would have been higher than cash costs. And cuts might have been deferred, because contango meant producers could continue to produce and store profitably, even if spot prices kept them underwater.

I often watch for backwardation because once we have it, there is no incentive to store, and so the futures market is dead for producers, with spot being forced into a decline as a result. This time I don’t think backwardation will be necessary. We still have contango -we have December 2016 trading at $37.50, December 2017 at $41.13, and December 2018 at $43.69. The contango is good news for financial investors. But for producers, the forward prices are well below marginal cost of production. And absent an incentive to produce, production will be cut.

On the demand side, demand growth has been strong as prices fell. But demand looks stronger than it is, simply because much of the demand is for storage, not consumption. Lower prices have not stimulated demand as much as they ought to have. Probably because the biggest growth markets for Oil, China and India ceased to pass the benefit of lower Oil prices to consumers a while ago.

At present I estimate over-supply at about 1.9 million barrels per day. We can look for increased production from Iran pushing the surplus to 2.5 million barrels per day. Then we have the offsets. As long as global GDP continues to grow at roughly 3.5% per year, long-term demand growth should continue to run at 0.9% to 1.1% per year, which translates to somewhere between 850K to 1.05M barrels a day. Then we have the shut-downs that higher marginal cost producers need to make which I am estimating at a minimum of 1.5 million barrels per day – this is a combination of shut-down of economically unviable projects, and declines caused by a lack of investment in new production and production enhancement which are necessary to arrest the decline curve.So there are reasonable odds that by late 2016 the market will return to balance.

Longer term, chances are that we will see shortages caused by the under-investment in exploration since late 2014.But we will feel the pain much later - perhaps as late as 2021 to 2025. 

Today, we might be seeing a compelling opportunity for investing in a distressed energy sector. But in the short-term, the markets will continue to trade on sentiment and momentum.Momentum remains ugly.But it is now so ugly, that a bit more ugliness caused by inventory builds as refiners shut down for maintenance and the switch to summer grade Oil might bring in a bottom!

• Brent Oil traded 0.63% below its average weekly close price over the past 4 weeks. Over the past five years, Brent Oil has traded on average 0.65% below its average weekly close price over the past 4 weeks, with a standard deviation of 3.72%. Assuming normalcy in distribution, the odds of a decline to over 0.63% below its average weekly close price over the past 4 weeks is 50%. With sentiment turning ugly, we could see Brent fall to $27.80, which is a level I believe we ought to hold for now.
• Brent Oil traded 15.80% below its average weekly close price over the past 10 weeks. Over the past five years, Brent Oil has traded on average 1.99%% below its average weekly close price over the past 10 weeks, with a standard deviation of 6.99%. Assuming normalcy in distribution, the odds of a decline to over 15.80% below its average weekly close price over the past 10 weeks is 2.41%.
• Brent Oil traded 26.52% below its average weekly close price over the past 20 weeks. Over the past five years, Brent Oil has traded on average 3.99% below its average weekly close price over the past 20 weeks, with a standard deviation of 9.81%. Assuming normalcy in distribution, the odds of a decline to over 26.52% below its average weekly close price over the past 20 weeks is 1.08%.
• Brent Oil traded 37.65% below its average weekly close price over the past 40 weeks. Over the past five years, Brent Oil has traded on average 7.5% below its average weekly close price over the past 40 weeks, with a standard deviation of 12.7%. Assuming normalcy in distribution, the odds of a decline to over 37.65% below its average weekly close price over the past 40 weeks is 0.88%.
• Brent Oil traded 40.11% below its average weekly close price over the past 52 weeks. Over the past five years, Brent Oil has traded on average 9.49% over its average weekly close price over the past 52 weeks, with a standard deviation of 14.21%. Assuming normalcy in distribution, the odds of a decline to over 40.11% below its average weekly close price over the past 52 weeks is 1.56%.

Over the coming 20 to 40 weeks I would look for a bottom forming at about $25.50-$27.50 shortly, before trading up to $40-$47 in-time.

Be warned, I have long been long and wrong oil. The presumption of economically rational decisions is a dangerous one to make unless you have a very long investment horizon.