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Lance Roberts

Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of "Street Talk with Lance Roberts",…

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Chart Of The Day: Natural Gas Suggests $33 Oil

Chart Of The Day: Natural Gas Suggests $33 Oil

In the last couple of months, the sharp reversion in oil prices has certainly caught the world’s attention. While the majority of economists and analysts continue to expect incorrectly that falling oil prices are a positive input to economic growth, the reality is that it is not. The negative impact to economic growth from the decline in oil prices are quite considerable when you consider that almost 40% of all the jobs created since 2009 have been in energy related industries.

Furthermore, many of those jobs are in the highest wage paying areas of the country that leads to more consumption and further job growth in other areas of the economy. In fact, for each job created in the energy sector there are nearly three jobs created elsewhere in the economy.

“What we've got here is a failure to communicate.” - Cool Hand Luke, 1967

As I discussed at length previously, the current problem in the energy price is a realization of a supply / demand imbalance.

"First, the development of the ‘shale oil’ production over the last five years has caused oil inventories to surge at a time when demand for petroleum products is on the decline as shown below."

U.S. Field Production

"The obvious ramification is a ‘supply glut’ which leads to a collapse in oil prices. The collapse in prices leads to production ‘shut-ins,’ loss of revenue, employee reductions, and many other negative economic consequences for a city dependent on the production of oil.”

Related: Did The Saudis And The US Collude In Dropping Oil Prices?

Once you factor in the negative economic consequences of the decline in oil prices, any perceived positive impact from lower gasoline prices by the consumer, will be quickly negated. (Read more here)

However, if you don’t believe me, here is T. Boone Pickens:

$33 Oil – A Return To Normalcy

While the economists and analysts are hopeful for a sharp recovery in oil prices, the current decline in oil prices is nothing more than a return to historical normalcy. Let me explain.

If you ask virtually any oil and gas professional, that has been around the industry longer than the graduating class of 2000, they will tell you that the historical relationship between oil and gas prices is roughly $8. The chart below shows the highly correlated history of oil and gas prices until 2008.

Natural Gas & Oil Price Diverge

Not surprisingly, the divergence between oil and gas prices came to fruition in conjunction with the massive interventions by the Federal Reserve, which lowered borrowing costs enough to sufficiently provide for funding of higher cost shale exploration. As Yves Smith recently stated:

“The oil and gas sector is capital intensive. Drillers have borrowed phenomenal amounts of money, which was nearly free and grew on trees, to acquire leases and drill wells and install processing equipment and infrastructure. Even as debt was piling up, the terrific decline rates of fracked wells forced drillers to drill new wells just keep up with dropping production from old wells, and drill even more wells to show some kind of growth. One heck of a treadmill. Funded in part by junk debt.

Junk bond issuance has been soaring as the Fed repressed interest rates and caused yield-hungry investors to close their eyes and take on risks, any risks, just to get a teeny-weeny bit of extra yield. Demand for junk debt soared and pushed down yields further. And even within this rip-roaring market for junk bonds, according to Bloomberg, the proportion issued by oil and gas companies jumped from 9.7% at the end of 2007 to 15% now, an all-time record.”

With an excess supply now realized, particularly as global demand continues to wane, oil prices are now returning back towards their historical long-term relationship.

Related: The Positive Side Of Low Oil Prices

If we assume that natural gas, which has been trading around $4 per BTU, has already returned a more normalized supply/demand range this would imply that oil prices have further to fall. The chart below is an extrapolation of the current West Texas Intermediate Crude price forecasted into 2016 on a monthly basis. It would currently require a decline in oil prices to $33 per barrel to return the WTIC/NatGas ratio back to its historic spread of $8.


Oil/Gas Relationship Returning To Normal

As T. Boone Pickens notes in his interview, the main supply / demand divergence is in the process of returning back towards equilibrium particularly in light of the deflationary forces that exist on the global landscape. While it is certainly feasible that we could see a sharp “snap back” rally from the recent plunge in oil prices, it is likely an opportunity to reduce energy exposure in portfolios before the next leg lower.

Just as a reminder, the last time oil prices fell 50% from their peak was in 1985-86. Oil prices then stayed at those levels until the turn of the century. The rebalancing of supply and demand could leave oil prices at lower levels for much longer than the majority of analysts currently believe. Considering that oil production related states have done the majority of the work related to the current domestic economic recovery, such an outcome could derail the hopes for a continued economic revival.

By Lance Roberts

Source - http://streettalklive.com/ 

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Leave a comment
  • Jacques on December 25 2014 said:
    To an amateur "Repressed interest rates" is the Fed's way of reversing the effects the "windfall Profit tax" had on the independent oil producer's ability to acquire/raise investment capital. And $33 dollar a barrel oil is winding down the capital formation in the industry so other sectors of the economy can rebuild / benefit. Personally, I would rather build a jet engine or design an airframe than shovel tar .....So hopefully, North Dakota has the reserves to normalize the fixed cost of capital back to 5% of total cost.
  • Lynn on December 25 2014 said:
    I feel dumber for reading this, NG and oil price decoupled years ago. There is no relation between the two. The basic premise of your article, is wrong.
  • Paul on December 25 2014 said:
    The author states, "Just as a reminder, the last time oil prices fell 50% from their peak was in 1985-86."
    This is false. Oil was $40 in 1991. Oil was $10 in 1999. Oil was almost $150 before dropping to below $40 in just a few months in 2008. Also, $8 is not a ratio. Ratios do not have units. And, I agree with the previous commentor that natural gas and oil cannot and do not have correlated pricing (especially when considering U.S. vs. world markets.. This is a very misleading and sensationalistic article.
  • jaycee on December 25 2014 said:
    Good article. As far as I could see, oil has been in an almost steady oversupply state for the past 4 years at least. I've been waiting for a correction for some time and was not exactly sure what had been keeping the price up. But you mentioned QE in the article and I think that is the answer.
  • Riaz on December 26 2014 said:
    I feel that US should stop depending on middle east any more.
  • Bassam on December 26 2014 said:
    I totally agree with Paul.
  • will on December 26 2014 said:
    How anyone can argue that, in the long term, it is good for the economy to pay more for oil? The only way living standards increase is when the price of goods and services go down. The 'majority of economists' will never think otherwise - cause it simply makes absolutely no sense to think that paying more for the same good is efficient.
  • rjsigmund on December 26 2014 said:
    how about worldwide gas prices?
  • Tran on December 26 2014 said:

    Living standards don't increase because of price decreases of goods and services. Living standards increase because the amount of goods and services being produced is greater. You cannot say that a third world country has the same amount of goods and services, or that their third world status is attributed to high costs of goods and services in their country.

    Of course, supply price equilibrium must be reached for there to be demand, and hence supply. However, you saying that living standards increase only because of price decreases is wrong. Prices decrease with more supply. Correlation does not equal causation.
  • dharmesh on December 27 2014 said:
    may be $47 is the price for reversal next month
  • HarryFlashmanHigson on January 13 2015 said:
    There is no way we will see 33$ per barrel(for a long time)simply because this is below the price of extraction these days.With the capital intensity of oil extraction rising at 10%+ per year everybody would be out of business by this time next year! What we're going to get is prices low long enough to crush production of tight oil in N.America and then a snap back of prices to a level that is profitable for most producers(either quickly(my bet)or slowly).Tight oil will likely come back,but not to the levels we see now for another 5 years or so,and probably not to the high(of production)we see now(or it's delayed peak in 6 months or so).
  • Arch_Stanton on January 16 2015 said:
    I think you got your figures wrong on the jobs created by the oil industry, from 2007 to 2012 total private employment increased by 1% (~1 million jobs). At the same time oil industry jobs increased by 40%, which is ~162,000 jobs, so the number of oil related jobs is still a tiny fraction of the total private workforce.

    The return to normalcy I believe is also incorrect, the vast bulk of future oil supplies we are trying to tap cost more than $33 dollars a barrel, a lot more. For example the UK north sea has ~80% of all future oil project viable only above $50 a barrel.

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