Stein's law says oil prices will rise
The current low level of prices, with Brent below US$45 and WTI flirting with US$40, is not sustainable.
“If something cannot go on forever, it will stop,” according to Herbert Stein, former chief economist to US President Richard Nixon (What I think: essays on economics, politics and life, 1998).
Stein’s law is one of the most simple but important statements in economic theory, yet it is remarkable how often it is forgotten.
It explains why oil prices crashed from the middle of 2014 after spending more than three years over US$100 per barrel.
Most commentators now accept a price of US$100 was unsustainable (though at the time there were plenty who predicted prices would remain at that level forever).
High prices were encouraging too much new production, especially from US shale, while causing consumption to fall in the advanced economies and slow in emerging markets.
The emerging supply-demand imbalance could only be resolved by a sharp price fall which was triggered in July 2014 after Islamic State fighters failed to seize Kurdistan’s oilfields and Libya resumed oil exports.
In retrospect, all this is obvious, but the clues were there at the time for anyone who tracked data on stagnant consumption and accelerating US oil production.
Stein’s law cannot predict when an unsustainable trend will reverse, only that it must do so eventually, and that the worse the disequilibrium becomes the bigger the correction is likely to be.
If Stein’s law was relevant when oil prices were unsustainably high in 2012-2014 it is also relevant in 2015 now oil prices are unsustainably low.
There are plenty of signs that oil prices have now fallen to a level that cannot continue over the medium and long term.
US oil production is forecast to decline more than 1 million barrels per day by September 2016, according to the US Energy Information Administration.
US shale oil and gas producers reported losses totalling US$24 billion in the third quarter of this year, up from US$15 billion in the second quarter, despite continued efforts to cut costs and improve efficiency.
Total non-Opec oil production is expected to decline by 600,000 barrels per day next year, according to the International Energy Agency.
By contrast, global oil demand has increased by 1.8 million barrels per day this year and is predicted to rise by another 1.2 million barrels per day next year.
Shale and non-shale oil producers have been able to cut costs and improve efficiency in response to the price plunge but producers may be running up against the limits of what they can do in the short term.
There is no doubt the current low level of prices, with Brent below US$45 and WTI flirting with US$40, is not sustainable.
The question is when rather than if the market must eventually move higher.
The problem is that disequilibria can persist, and even get worse, for a considerable period of time before the inevitable correction occurs.
The oil market’s underlying supply-demand imbalance got progressively worse between 2012 and 2014, but a series of supply disruptions (Libya, Iran, Iraq, and Syria) masked the unsustainable trajectory until July 2014.
The same could now happen in reverse, with a series of supply increases (post-sanctions Iran, non-Opec fields planned before 2014) masking the unsustainable slowdown in supply and acceleration in demand.
Most commentators think the market will be under-supplied by 2018 without more investment in production, but there is less agreement on whether the imbalance will start to become apparent in 2016 or 2017.
For their part, many hedge fund managers are convinced things must get worse for oil producers before they get better to force a more speedy adjustment.
Hedge funds have amassed a near-record short position in futures and options contracts on US crude oil, betting that prices will fall further.
On November 17, hedge funds and other money managers held short positions equivalent to 154 million barrels of oil, up from 90 million in the middle of October, according to the US Commodity Futures Trading Commission.
This is the third time hedge funds have established a large short position in 2015, with previous peaks at 163 million barrels in early August and 178 million in March.
Both big short positions coincided with sharp drops in prices, which were then abruptly reversed as the hedge funds tried to reduce their positions and lock in prices, sparking rallies.
In this case, many hedge funds and commodity dealing banks say prices must fall further to maximise the pain for US shale producers to enforce a change of course.
But the gamble is a risky one because prices already appear stretched and the funds are betting that they can get in and out of the positions before the adjustment becomes apparent to the rest of the market.
In effect, the hedge funds are betting that they can ride the growing disequilibrium in the market before Stein’s law kicks in and forces a correction.