Expect Oil to Rebound

My model for forecasting oil prices has three top-level factors, represented graphically by arrows pointing up, down or sideways. An up arrow is colored green and points to higher oil prices. A down arrow is colored red and points to lower oil prices. The sideways arrow is colored grey and suggests that the relevant factor is neutral with respect to oil prices.

Of course, there are innumerable subfactors behind each of the main factors that form a lattice of cause and effect and that lend themselves to inferential methods. Still, the top-level “three arrows” predictive analytic model has served us well when it comes to oil prices.

The first factor is basic supply and demand. If global economies are growing strongly or if supply channels are jammed or restricted in any way, that arrow will be green, indicating higher prices. Conversely, in a global slowdown or a situation in which Russia, Saudi Arabia and the U.S. have their taps wide open, the arrow will be red, pointing toward lower prices.

Your correspondent inside the Grand Mosque in Kuwait City, Kuwait. The Grand Mosque is one of the largest mosques in the world. My frequent visits to the Middle East are useful for understanding the extent of Arab cooperation in setting oil prices and the geopolitics of oil output in the Persian Gulf region.

The second factor is inflation/deflation, which can influence oil prices independent of growth. It’s entirely possible to have inflation in a recession (called “stagflation”) or to have deflation in a growth phase.

Japan has experienced this since the 1990s, and the U.S. has had growth with disinflation at times from 2009–2017. Inflation/deflation respond to real interest rates, capital flows and exchange rates. Inflation is a green arrow and deflation (or strong disinflation) is red.

The third factor is geopolitics. Any credible threat to close the Strait of Hormuz or attack oil production or shipment facilities will produce a green arrow pointing to higher prices. Economic sanctions, a form of financial warfare, will also produce a green arrow.

Likewise, cooperation and peace among major oil-producing nations — or at least the absence of hostilities — will produce a grey (neutral) or red (lower) arrow with respect to oil prices.

The geopolitical factor has to be treated carefully. Most analysts assume that a war among oil-producing nations is automatically a cause of higher oil prices. That’s not true unless oil facilities are directly targeted. A war among oil suppliers actually results in higher output, not lower, as the warring powers are desperate to earn cash to fight the war.

The best example of this was the Iran-Iraq War of 1980–1988. From Sept. 1, 1983–Feb. 1, 1986, during the height of the war, oil prices plunged 67% from over $30 per barrel to $10 per barrel as both Iran and Iraq pumped oil furiously to earn hard currency to sustain their war efforts. Oil prices do spike when war is threatened but tend to fall once the war begins.

Forecasting oil prices using this model is most difficult when the factors are sending mixed signals. For example, the model today shows that global growth is slowing, which puts downward pressure on prices. But Russia and Saudi Arabia, two of the world’s “Big Three” oil producers (along with the U.S.), are considering cutting output, and Saudi Arabia is reducing oil shipments to the U.S.

These tactics push the price of oil higher. The inflation/deflation indicators and geopolitical metrics are also putting out mixed signals.

Oil and gold are two commodities that can properly be regarded as money or money substitutes in global currency markets. With this complex data landscape, what is the outlook for oil prices in the months ahead?

The single most important factor in the analysis for oil is the supply/demand factor.

Global growth is slowing, which normally presages lower oil prices. In an extreme case, a global recession or financial panic would result in lower prices. But the growth slowdown is not yet at that stage. Even if demand for oil flattens, Saudi Arabia can single-handedly boost the price simply by cutting its output.

That’s what is happening.

Saudi Arabia has cut oil exports to the U.S. This forces the U.S. to use more of its own oil and forces a reduction in U.S. inventories, which are followed closely by analysts and traders. The result is higher oil prices as supply in the U.S. shrinks.

This maneuver by Saudi Arabia is partly in retaliation for a tactic used by Trump earlier this year. Trump wanted lower oil prices ahead of the U.S. elections. He also threatened severe sanctions on Iranian oil exports.

Saudi Arabia helped the U.S. by increasing their oil output to make up for potential Iranian shortfalls and to help moderate price increases prior to the U.S. midterms. The result was a severe crash in oil prices visible in Chart 1 below:

Chart 1 – Oil Prices in Dollars Per Barrel (Right Scale):

Trump enjoyed the lower oil prices but did not hold up his end of the deal when it came to Iran. The Trump administration granted sanctions relief to all of Iran’s major oil customers, including India, China and Japan. The U.S. got low oil prices and Iran got relief from sanctions.

The only loser was Saudi Arabia, which bore the brunt of lower prices. Now it’s Saudi Arabia’s turn to get even by reducing supply and driving prices higher.

The inflation/deflation factor is neutral at the moment. There is certainly fear of inflation among central bankers wedded to flawed Phillips curve analysis, but the evidence for actual inflation is almost nonexistent. A disinflationary trend is just as likely based on Fed overtightening through a combined policy of rate hikes and money burning called “quantitative tightening.”

The geopolitical factor is also neutral. There is potential for a huge geopolitical flare-up if the Iran sanctions are tightened over the course of 2019 and 2020. A geopolitical shock in the Persian Gulf could send it back to $100. With Trump having backed out of the Iranian nuclear deal this spring, that possibility remains.

But for the moment, the situation is tense but calm.

With geopolitics and inflation/deflation both stuck in neutral and the supply/demand factor pointing to higher prices as the Saudis reduce supply, the net of the “three arrows” is higher oil prices in the near future. Rising dollar inflation could also take prices higher.

Any evidence of actual inflation or a sudden increase in tensions with Iran could cause the upward tendency to skyrocket from here.

Regards,

Jim Rickards
for TheDaily Reckoning