The Black Swan Spotter...Which Saw the Oil-Crash coming; now says the “Invisible Hand” will push Brent to $85 by Christmas

Commodities / Crude Oil May 26, 2016 - 10:39 AM GMT

This is a long article...in summary:

The Short Story:

$85 by Christmas 2016 sounds as far-fetched as the notion that when Oil was $100-Plus, it would crash!
The Big Idea then, was that was a classic price bubble – and bubbles always bust
That was based on a boring valuation for “Other-Than-Market-Value” (OTMV) done in line with very boring International Valuation Standards; nothing radical, no Black Magic, no Black Swans http://www.romacor.ro/legislatie/08-ivs2.pdf
The “alleged” price-bubble, led “allegedly” to over-investment which led to over-supply
That was probably thanks to central banks printing money to stimulate what Ludwig Von Mises called “mal-investment”, which is why you have central banks and “God’s Workers” ordained by Goldman Sachs
The over-supply eventually caused a bust, predictably
And then “over-investors” (and/or their banks), lost their shirts. That’s normal, it happens all the time; the only question is who pays; the latest idea of the Fed is the grand-children do.
The model says bubble/bust is zero-sum and so the bust is over; because the supervisor of God’s Workers says so
OTMV today appears to be about $85, so that’s where the price is headed now
Unless shale oil comes back in a big way – that’s the only caveat.

The Long Story:

Last August the former-President of Shell told a reporter on CNBC; “no-one saw this (crash) coming”.

http://www.cnbc.com/2015/08/28/oil-volatility-will-continue-fmr-shell-president.html

He should know, Shell had billions of dollars riding on $100-Plus Oil and employed armies of experts to look-out for what came. That in the event, they didn’t see coming. But the former-President was not 100% correct; one model did see it coming. In May 2012, just after Brent hit $127 that model said:

“The correct price of oil right now valued according to what the world can afford to pay (without suffering unduly), is about $90 (Brent). So at $127 oil is a 40% bubble, bubbles do have a habit of popping once they get to 40% over the “fundamental”.

http://www.marketoracle.co.uk/Article27982.html

No one would argue that $28 from $127 (Brent) was not a “pop” or a “bust”. Solving that model for now says the bust/pop is almost over and so the oil price will go to $85 soon...that’s of course if it’s a good model.

So is it a good model?

That’s a silly question – of course its nuts!! Everyone knows bubbles and busts are driven by Black Magic and invisible Black Swans, which is why most economists and all central bankers could not see the housing bust coming, how could they? Invisible Black Swans are...Err...invisible! Duh!

Although to be fair, once the housing bust started the Black Swan High Priest, Allan Greenspan, did concede, in a roundabout sort of way, as was his wont, that what had happened might...Err...perhaps...have been a bubble, and there might have been a “flaw” in his thinking. Big Flaw!

But taking a step back, let’s be reasonable and logical here, surely, if no-one saw the recent oil bust coming (if that’s what it was), and, now, no one says it was a bubble prior, that PROVES beyond any reasonable doubt that it can’t have been a bubble, that caused the bust...doesn’t it? Nothing complicated there...that’s what Larry Summers teaches in ECON-101 at Harvard University, and who can argue with that?

It’s obvious, it must have been them pesky Black Swans again, the ultimate Weapons of Financial Mass Destruction. MEMO to Bomber Command – “Search and destroy all Black Swans, nuke them if necessary, and water-board all survivors!”

But...Err...perhaps not? Here’s an idea, just before anyone goes out and spends $3-trillion bombing some unfortunate third-world country back to the stone-ages, to teach them to stop harboring Black Swans, let’s say, just for the sake of argument, that perhaps it was a bubble caused primarily by financial stupidity, and then because there was a bubble, there was, inevitably and predictably, a bust/pop. Just an idea!!

So how do you spot a Bubble?

The first complete version of the valuation model was floated in November 2010, the main focus then was to say that price at the time ($80) which had bounced from $35, was not a bubble; and unless there was a war (always possible), or a bubble followed by a bust (less common; and you need more than a brace of Black Swans with a sprinkling of Black Magic for one of those), oil would never go down below $75 Brent. The explanation, or if you like, the excuse, for why in the event it just did go down below $75, five years later, is there was a bubble in-between. http://www.marketoracle.co.uk/Article24057.html

Subsequent updates on the 2010 analysis predicted a $67 bottom for this bust, so that was wrong too, but the general direction was right. This post looks at the reasons for why that was “conservative”, and where we are now.

The model to spot the bubble was simply a valuation done using the boring-old principles of International Valuation Standards (IVS), which of course they don’t teach at Harvard University. Nothing particularly radical there, but the valuation does rely on three somewhat unconventional ideas, well “unconventional” if you are a day-trader or a Keynesian-economist.

Unconventional or not, actually the guidelines put out by IVS say the person doing the valuation can use whatever crazy ideas he wants, so long as he explains how he came to his valuation opinion in words his client can understand, and more important from a practical perspective, that the client buys into...otherwise he might not pay the bill. That’s why the valuation approach used for a tribal chief deep in the jungle, might well be different from how the same issue was approached for a Wall Street banker who believes in the existence of invisible Black Swans, and might, for example, include references to chicken bones and entrails.

There are a few other points about valuation worth mentioning, in particular that the purpose of the valuation and conflicts of interest must be clearly declared. For the record the purpose of the 2010 valuation was to give an opinion on whether the then doubling of the oil prices over a few months prior, meant that there was a bubble. My “purpose” then was to provide a basis for evaluating the feasibility/risk of building a jack-up for deployment offshore ARAMCO, that needed a four-year time-span to pay back at an oil price above $75 (my day-job). And the main reason I post is I get comments, like sort of crowd funding except I’m looking for ideas/feedback rather than money.

The purpose of this valuation (this post) is mainly to try and persuade some bankers who have been cowering under a table whimpering in terror and mumbling “$20 next...$20 next”; that it’s safe to come out now; and so please will they pull themselves together and put up money to build another jack-up. I suppose I should also declare that I have had a little flutter on some futures for October-dated Brent, although sadly, I’m not so important that, that information will likely have any effect on the market.

Formalities aside – moving on:

Big Idea #1: Oil, like everything else, has what Warren Buffet calls, an intrinsic value.

That’s what International Valuation Standards calls “Other Than Market Value” (OTMV). I don’t imagine the armies of analysts employed to see-it-coming by Shell would know what one of those was if it hit them over the head with a stuffed-black-swan; but for this analysis, that’s a very important concept.

Leaving aside, why, sometimes markets get confused so OTMV is not reflected in the price of the day; when the price goes radically higher than OTMV that’s called a bubble. Bubbles are always followed by busts, which is when price goes radically lower than OTMV, when that happens you can be pretty sure that what happened before, was a bubble. That’s not a radical idea; plenty of other people had the same idea for other markets, just for some reason no one seems to think that applies to the oil market.

Big Idea #2: Price is what you pay; value is what you get (Warren Buffett).

I remember watching Warren Buffett reluctantly sitting down to be interviewed by a ditzy blonde; I think it was on CNBC. She asked him in a sugary voice, “Mr. Buffett, can you tell me, please, how you know when to buy and when to sell?” Mr. Buffett, ever polite and courteous, shifted in his chair; and for a fleeting moment the hint of a pained expression crossed his face, as if he could easily explain his whole life philosophy in a five second sound-bite. But he managed, he said, “Well for a start, I know how to do a valuation”.

When Buffett said “valuation” he wasn’t talking about looking at the price on the sticker and paying that, or checking the futures market, he was talking about OTMV. Sadly they didn’t have time to explore how to do that sort of valuation in the interview, but this is the thing, when OTMV is less than the price of the day, you buy, when it’s more, you sell, unless that’s a bubble or a bust in which case, take care. The hard part is to know what OTMV is.

The important concept for working out OTMV is that it’s not the PRICE other people might pay for something in the market-place...today, that matters; it’s what the something is worth to the owner....VALUE. To give an example, you probably wouldn’t pay anything for my left ear if it was surgically removed and presented to you wrapped up in a newspaper. But it’s worth a lot more to me than that.

There are two elements of OTMV, depending on whether you are a buyer or a seller.

People buy oil because they can do something with it and make a profit doing that; that’s the whole point.

Or alternatively they do something else that has a value to them; like tearing down a dirt-track in the F-150 with the wind in your face; singing LA-Freeway along-with Jerry Jeff Walker on the radio...FULL-BLAST. And in a free world, who can argue about the value of that?

The $90 in the 2012 model was an estimate/opinion of the “break-even” price over which it did not make economic sense (at the time) for some buyers to buy; although sometimes they do buy even if they can’t afford it (price more than value), usually because they can access easy money to borrow so they think they can afford it, which is one reason you get bubbles.

Sellers on the other hand are interested in replacement cost, that’s what their oil is worth to them. If I have an oil field that cost me $20 (say) to produce a barrel of oil after depreciation, time value of money etc, etc; that doesn’t mean I want to sell that oil at $20 plus a margin, say for $25, even though I can. Because I know that to replace that oil, dig another hole etc, it’s going to cost me, or my customer, (say) $60, and I know that he will have to pay my price, or go away and drill himself his own oil well. So in those circumstances even though I know the buyer can afford to pay $85, I might offer say $55 to discourage him from doing that.

So OTMV is two numbers and International Valuation Standards says that the person doing a valuation, as in getting paid to do one rather than pitching a line on Bloomberg...should carefully consider and use his professional judgment, to decide which one to use; I hope that makes sense? My point is, OTMV is a theoretical number and no one ever knows for sure what it is; except perhaps for Mr. Buffet, because he most certainly knows how to do a valuation, and definitely much better than I can.

In 2010 there was talk of Peak Oil; most people figured the replacement cost at that time was about $80 per barrel, which was in line with the model’s estimate of the “Affordability” OTMV of about $90. So then there was a bubble and at those prices, a lot more oil was found and put into production, particularly U.S. Shale oil; and it’s all that extra production that is contributing to the glut, because the way it works with oil is that all the money is up-front, keeping the tap open once the oil is flowing is tiny compared to that cost. $100-plus oil was not sustainable because it encouraged people to go out and find too much new oil.

What may have changed, but we don’t know now, is that after investing all that money in shale oil, the technology has improved, and so, combined with the fact that second-hand horizontal drilling rigs and sand machines are these days selling at pennies on the dollar, as is prime acreage; the shale oil drillers may be able to stop just drilling horizontal on existing plays and doing the fracs on the juiciest DUC’s; which is pretty much all they have been doing since the bust started. And instead going out and starting brand-new plays; albeit at a lower price than $100+ dollars, which was the price many were struggling to make money at before.

Who knows? You can listen to the experts, they will tell you anywhere between $40 and $80 (Brent), but no one will know for sure until the price goes up and/if drilling starts in earnest or not. If that happens, assuming Saudi Arabia decides they have taught everyone a lesson in free-market-economics that they won’t forget in quite some time, and eases up a bit, that “Replacement” OTMV price will be the critical number if it is less than the “Affordability” OTMV. When those two and the price of the day, are all about the same number, the market is in equilibrium.

In the event Saudi Arabia (or anyone else) decides to shut out producers who need a number close to the “Affordability” OTMV to bring on more supply (the model says about $85 today); that could cause a “reverse bubble”, which is what happens when prices are artificially constrained lower than OTMV, which cramps investment, which eventually leads to a bubble in price, which leads to over-investment, and round you go.

Big Idea #3: Bubbles and Busts create no net economic value.

I think that is pretty much my idea but I’m happy to give anyone else credit. The timeline was I “discovered” Farrell’s 2^nd Law which says in a market any departure in price from the equilibrium (another word for OTMV), will always be followed by an equal departure, the other way. I used that logic to predict, in 2009, that the S&P-500 would bottom at 675 which it did, and then to correctly map out the trajectory of both the S&P 500 and U.S. house prices for the next five years.

http://www.marketoracle.co.uk/Article8293.html

And no, since many people ask, I need to say that sadly I did not make any money out of that; I was just messing around, playing with ideas and thinking about numbers to put into forward planning assumptions I was working on. I’m an analyst and my horizon is five-to-ten years. The main reason I write is because I get comments, and once in a while I’m lucky enough to get one that makes me say to myself -“DARN!! Why didn’t I think of that?”

One comment I got was, “perhaps it’s not the number; perhaps it’s the area?” That stopped me in my tracks. My computer crashed soon after that so I lost the link, just a simple random e-mail from cyberspace changed the whole way I was thinking. Hey, whoever you are, thank you very much! Please write – you know my e-mail, I LOVE YOU!!

That, by the way, explains why the prediction that oil prices would bottom at $67 in the bust, was wrong, Farrell’s Law is a rule of thumb; there is something else.

In a sustainable economy, in every transaction, the buyer and the seller both win, so both live to trade another day. In a bubble the seller get’s paid too much (he wins) and the buyer pays too much by agreeing a price he cannot afford (he loses). In the bust the seller is paid less than OTMV and sometimes less than his cost, but for various reasons he has no choice (he loses), and the buyer pays a lot less than he can afford (he wins). So this is the Big Idea...that is not “sustainable”, and so if life must go on, net everyone has to end up square, on average, and all that happened was a re-distribution of wealth, like a wild-fire re-generates forests. Like a pebble thrown in a pond creates little waves where the crest is exactly the same distance above the “equilibrium” as the trough is below, and the disturbance moves things around, but in the end the pond is flat and the level of the water is unchanged. In the grand scheme of things, nothing happened.

If that’s right since early 2011 - the start of the bubble, and if the model’s calculation of OTMV is right, the whole world, in aggregate, paid about $2-Trillion more for oil than they could afford, likely the reason for that was thanks to QE-X so they could get debt to finance current expenditure so they thought they could afford it.

Big Idea #3 says the customers will have paid $2-Trillion less for oil than they would have if they had paid OTMV, before the bust is over, because the “unseen hand” is going to make sure that there is a credit note to cover the past over-payment, although sadly the people who benefit from the re-fund may not be the same people who overpaid, such is life.

Weird!!

Now that all sounds pretty weird; so just to be CRYSTAL clear, what this dude/nutcase who doesn’t even believe in invisible Black Swans, is saying, is that an “unseen hand” is going to square-up everyone who got diddled in the bubble because they foolishly paid more than an “unseen number”; that no one knows for sure what it is?

Uh-Huh...!!

Very weird – but that’s how it played out for the bubble and bust on the S&P-500 and U.S. House prices, so perhaps that could happen for oil, assuming the Saudi’s don’t engineer a reverse bubble, which they might.

Details

In 2010 I was wondering, what’s a way to figure OTMV for oil? Previously I had used the NPV of GDP/Housing stock to figure that for housing, and GDP/Long-term interest rates, for stock-markets. The logic there was for housing, long-term, people can only afford to pay a certain proportion (about 20%) of their disposable income on a place to live, and long term the value created by companies listed on stock markets is a certain proportion of GDP. That seemed to have worked reasonably well.

So I figured perhaps OTMV for oil was a function of Total World GDP divided by consumption of oil, at that time; then I tested that on 50-years data http://www.marketoracle.co.uk/Article24849.html; seemed to work, and at least the dimensions were right...$/b. The implicit logic is a bit like the one on housing, it’s the number of units that matters, not the size of the units.

Then by way of confirmation I looked at how Farrell’s Law had played out in preceding bubbles and busts, by way of calibration; I ended up with a constant in the algorithm of 3.3%. Later looking at the idea of “bubble & bust creates no economic value”, I changed that to 4%.

There is another way of looking for OTMV for oil which Art Berman talks about. He says that there is a price where “Demand Destruction” starts http://oilpro.com/post/24563/returning-to-market-balance-high-must-prices-to-save-oil-industry. That’s another way of working out OTMV and using that approach he also ends up with about $90, same number as me. Of course there is more than one way to do a valuation, but if two different approaches end up with a similar answer, you start to have confidence in both models. That said, I think I got a better model than Art (of course I do), my view is that’s a bit misleading because when prices went over $90, people still bought so demand was not destroyed, likely because they could borrow, until they went broke. But all the same, we do seem to agree in the “answer” which is the important part.

This is my estimate of OTMV done annually; I’ve put some of the previous calls based on the model on the chart:

So then I calculated, each month how much oil was consumed x the price over OMTV, shown in this chart:

There is no trick in how those numbers were calculated. The base line for OTMV is exactly per the algorithm put out in 2010 except, as I remarked, on further reflection over the past five years I changed the constant to 4% from 3.3%. Forget about now, the model says in the 2007/08 bust the world paid $767-billion more for oil than they would have if they had paid OTMV, and then, no tricks, I promise, I just pressed the button on the computer, it says in the 2008/10 bust, they paid, exactly $767 billion less.

That’s so weird it’s almost spooky...the “unseen hand” of the market-place, paying out refunds!! What will they think of next!?

Now how about for something REALLY spooky!!

Reference the unseen hand of the market’s unseen loss-adjuster that makes everyone whole again; one important cause of bubble-and-bust is prices getting fixed by un-regulated derivatives, often written by people who call themselves “God’s Workers”, like Goldman Sachs.

On the subject of God...since Goldman Sachs brought it up:

Not many people know that a long time ago, The Prophet Mohammed (Peace be Upon Him), was approached by the good-merchants of Mecca, or Medina (I can’t remember which), with a scheme to fix food prices that would bring “stability” in the market. Apparently, so the story goes, The Prophet Mohammed (Peace be Upon Him), got slightly annoyed and he said...”Only God Fixes Prices”, and he sent the good-merchants packing with a flea in their ear (1). Looks like he beat Adam Smith, Ludwig von Mises and all-that crowd by a thousand years reference the fundamental cornerstone of free-market economics, or perhaps...one must not forget, wasn’t he just a humble messenger?

There’s more, another facet of Islamic scholarship as it evolved later, is the idea that sometimes, it’s OK for the government to fix prices below OTMV, if that’s in the best interests of the less fortunate part of the population, i.e. poor people; which looks suspiciously like an early-onset attack of Keynesianism, one thousand years ago.

Look at it that way, what Saudi Arabia is doing now by just keeping pumping, is entirely consistent with that idea, like perhaps they figured out that during the bubble, their poor but loyal customers paid too much, so all they are doing now; is giving them a refund. That’s simply good business, all this model says is that the refunds almost all got paid out by now.

So when Al Nuaimi says:

"Let me say for the record, again, we have not declared war on shale or on production from any given country or company. We are doing what every other industry representative in this room is doing. We are responding to challenging market conditions and seeking the best possible outcome in a highly competitive environment. Efficient markets will determine where on the cost curve the marginal barrel resides." (Reuters).

He means exactly what he is saying. And perhaps the reason the Saudi’s are so clear in their strategy might simply be that underneath all the smokescreens, that’s consistent with their beliefs, and when they keep going on and on...and on and on, about “Fair-Price”, that actually means something to them?

Hey Mr. Donald Trump, Mr. Genius Billionaire who would be ten times richer if you had put your dad’s money in the stock-market, I guess you got plenty to say about that?

Bottom line, if you fix prices; don’t ever imagine “someone” is not looking or that you won’t be sorry one day, like if you are walking in a forest, don’t start a little fire, just for fun or to keep off the mosquitoes (brutal in Alberta these days); because (a) someone might see you and (b) there may be unintended consequences.

So what’s going to happen next?

Three possibilities:

Saudi Arabia will continue to play hard-ball

I suspect Saudi Arabia saw Shale Oil as a much bigger threat than they publically admit. Right now U.S. Shale oil is effectively dead, the horizontal rig count is 15% of what it was at the peak, Q1-2016 proppant shipments went down 68%, over the previous quarter, so presumably that means they have run out of DUC’s.

But who knows, perhaps the Saudi’s want U.S. Shale (read “Hi-Cost Producers”), to be more dead than dead? Personally I don’t think that would make sense for them, they have made their point, or more correctly the invisible hand of the market has spoken, and OK they don’t absolutely need the money, but I imagine it might come in handy, for a rainy day perhaps? And by the way, it does rain in Saudi Arabia, from time to time, causes chaos.

All they have to do is ease a little and the price will go to $60; then if the shale oil drillers don’t come pouring back (I doubt they will), ease a little more and watch the price go to $70; until it reaches $85 which is what I reckon OTMV is now, and when it gets there don’t let it go over, just keep an eye out for any significant increase in shale oil drilling.

Another reason to anticipate a little, easing is that some of the higher cost producers, particularly those where a high proportion of the oil revenues go directly into the London and Swiss Bank Accounts of the local glitterati, and almost none get’s spread around the local population (not the case in Saudi Arabia and particularly not in U.A.E.), when there is a choice between (A) keeping the glitterati in the lifestyle to which they are accustomed, or (B) buying spare parts for the taps, they go with Plan A; which is why oil production from Nigeria and Venezuela is falling off a cliff.

Also, in the event shale oil drilling shuts down, that production will drop by about two-million b/d in a year. But it would probably be a strategic mistake for Saudi Arabia to risk getting blamed (whether with justification or not), for the total destruction of the U.S. Shale Oil Industry, surely there ought to be a way for two long-term allies to compromise a bit?

Also too much hard-ball by Saudi Arabia could result in a “reverse-bubble”, i.e. under-investment for the long-term caused by prices being artificially depressed for too long, which would down the road cause a bubble (defined here as price more than “affordability” OTMV), which would give the “high-cost-producers” a chance to roar back in and improve their technology some more, which long-term might not be a good idea for the low-cost producers.

The Saudi’s have been saying for years, that what they want is stability (i.e. no more Boom-Bust), and they want the price to be “Fair” so that buyers can afford the oil without suffering unduly or going into debt, and the sellers have sufficient incentive to go out and find more oil to replace what is being burned. In other words, they want the price to be OTMV, which they say (well they used to say), and this model says, is about $85 today.

Look at the chart – if this analysis is right, almost all of the “over-payments” have been refunded, which suggests the price is likely to head up to OTMV soon, by October perhaps.

U.S. Shale oil can make big money if Brent is less than $85

That’s the wild card. EIA puts out estimates of total and legacy production looking forward a month, from which you can work out new oil, brought on line, which works out at 150,000 b/d in June 2016. That is “only” 34% of the peak in December 2014. Likely the reason for that is they are simply drilling out existing plays and fracking the DUC’s, but that can only last so long.

There again I was talking to a good-old-boy from Huston the other day who said he was putting in four-six-hole pads getting ready to drill a new play, and he knows people who can go to work at $50 (Brent). But of course, there is a lot of what Texans are well known for, floating around in Huston.

I have no way of telling; if they can, whatever price they can “break-even” at will dictate the price worldwide, regardless that according to this valuation model, the customers can afford $85. Likely over the next year we will find that out, although that will of course also depend on how the Quantum-Theory-of-Banking plays out. That says bankers exist in only two possible quantum states, (A) Insatiable Greed (B) Abject terror. Problem is to get them to switch from Quantum State-(B) to Quantum State-(A) requires a lot of energy; so much so that for a big bust like this one, sometimes you got to throw it out of helicopters, but it looks like that may be going out of style.

Big Idea #3

If you believe in Big Idea #3, then it can be useful as a prediction tool, or more precisely for an analyst looking into the future, it can provide “a very boring buttoned-down reasonable basis for developing long-term low-case planning assumptions”, as in the ones you can take to the bank that don’t get laughed at, or shoved in the trash can.

Adding up the area on the chart; the $2-Trillion the world overpaid in the bubble will have been refunded by September 2016, at which point, according to the model, the price will go to $85. I think that is the most likely scenario, because I don’t believe shale oil will come back big at that price, and now it’s not anymore in the best interests of the low-cost producers for the price to stay radically below OTMV.

Acknowledgements:

I thank my friend Hussein Al Amery who was kind enough to check if I had the story more or less straight about The Prophet Mohammed (Peace be upon Him), and tell me whether he thought what I wrote might be likely to cause offence, which was not my intention. In the event I have caused offence to anyone, who I did not want to offend; I apologize.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe. Ex-Toxic-Asset assembly-line worker; lives in Dubai.

© 2016 Copyright Andrew Butter- All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Andrew Butter Archive

The Long Story:

Last August the former-President of Shell told a reporter on CNBC; “no-one saw this (crash) coming”.

http://www.cnbc.com/2015/08/28/oil-volatility-will-continue-fmr-shell-president.html

http://www.marketoracle.co.uk/Article27982.html

So is it a good model?

So how do you spot a Bubble?

Formalities aside – moving on:

Big Idea #1: Oil, like everything else, has what Warren Buffet calls, an intrinsic value.

Big Idea #2: Price is what you pay; value is what you get (Warren Buffett).

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