The Experts, the Oil Price and the Wisdom of the Market

A well known Wall Street economist once told me that when he entered the financial arena his boss said to him that “markets make forecasts, forecasts do not make markets”.  At the time, that observation was hard for him to swallow, because he believed that insightful fundamental analysis should win out, that market prices should come around to the fundamental view. He learned, in time, that his boss was right.

Forecasts tell you what the market has done, not what it is going to do.  Ignore experts’ forecasts. They are wrong.  Use experts to gain insight into how industries, companies and macroeconomic phenomena work.  Once you understand the processes underlying what you are assessing, contrast that understanding with market pricing and trends to determine whether an investment idea makes sense.

Trends and valuation will tell you more about what may happen than forecasts. I will give two examples of this kind of analysis. My first example is why the current upward slope of the oil curve may indicate that prices may have bottomed and could rise. The second example examines why the performance of energy stocks relative to the oil price since 2011 was a warning signal about the profitability of energy companies and ultimately about the oil price.

Let’s start by looking at the forecast of the Brent oil price for 2015 versus the spot price for Brent.  The forecast tracks the market price of Brent. The median forecast does not anticipate the oil price plunge; it lags it!  There is no information here other than the fact that forecasters have collectively been monitoring the oil price.

Brent median forecast (blue), Brent futures contract price (orange)

Brent median forecast (blue), Brent futures contract price (orange)

This next chart shows the oil price in the upper panel and the oil curve in the lower panel. The oil curve has been upwardly sloping, a.k.a. in contango, since August 2014. I define the oil curve as the 13th contract minus the 1st contract and, by doing so, eliminate seasonality.* A positively sloped oil curve precedes price rises. The price rises are not instantaneous, but they do tend to follow when spot oil prices are below future oil prices. I say tend to, because the amount of oversupply and low short run demand elasticity may necessitate that the oil price stays low and the curve stays upwardly sloping for longer than it has had to in the last 15 years.

Brent futures price (blue), Price of 13th Brent contract minus price of 1st Brent contract (bottom panel)

Brent futures price (top), Price of 13th Brent contract minus price of 1st Brent contract (bottom)

Be that as it may, the contango helps the oil market rebalance. Oil is bought in the spot market, stored and sold at the higher future price, assuming that storage costs can be covered. Thus, the contango allows oil to be stored profitably until production falls or demand recovers.  This is happening on land in places like Cushing Oklahoma, the delivery point for West Texas Intermediate, the US benchmark crude and in tankers at sea for other kinds of oil.

If you believe this analysis, then think about what might sense to buy if oil prices have stabilized.  Consider oil related bonds.  See my earlier post: Should You Fade the Plunge?

The relative performance of energy stocks in the MSCI all-country world index (ACWI) largely tracked the oil price from the inception of the sector index at the end of 1994 until the financial crisis, which is the first large divergence on the chart.  I think we can chalk up that divergence directly to the financial crisis and leave it at that.  ACWI energy, relative to ACWI, resumed its tracking of the oil price until 2012.

From March to June 2012 the oil price fell sharply and subsequently recovered to trade in a range until mid-2014. Energy stocks did not follow the oil price after June 2012.  They fell from then through mid-2014, rebounded a bit and then plunged along with oil prices. That divergence from 2012 to 2014 caught my eye.

BrentvNRGsec

Brent oil price (blue) | MSCI energy sector (gray)

I asked myself why this was happening.  My suspicion was that the amount of investment that had gone into the energy sector  had probably outstripped the opportunities there. Did I foresee the late 2014 oil price plunge? No. What concerned me was that the divergence between sector performance and the oil price, given the flow of investment to the sector,  pointed to future underperformance.

Where I was working at the time, we scaled back commodities in our strategic asset allocation in 2013 and recommended an underweight stance in commodities on a tactical basis in 2014. Some of my reasoning in supporting those recommendations was based on this analysis.

* Seasonality means that there is a pronounced tendency for prices of an item to be biased upward or downward at particular times of the year.  In the northern hemisphere, gasoline prices tend to be high in the summer as people set out on driving holidays and low in the winter. See below:

Gasoline

NYMEX unleaded gasoline contract: cents per gallon. Note the higher prices in the northern hemisphere summer.

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