Why it's so hard to know when oil will bounce back: Don Pittis

"I'll hang on to my oil stocks a while longer," a friend told me in a recent email.

He was responding to the closing line in a piece I wrote last month on the global economic shocks in store if oil prices stayed low. "No matter how far they fall," I wrote at the time, "one day oil prices will rise again." 

At that point, oil prices had merely fallen below $70 US a barrel. The further they fall, the more likely that closing line is to come true.

Whether it's for my friend with his oil stocks, for the Alberta government and its revenue or for the very survival of the Russian government, the important question is when that rebound in prices will arrive. But finding the answer is difficult.

• Oil price decline could lead to global shocks
• Oil price falls below $70 US as OPEC leaves output unchanged

My suggestion that falling oil prices would cause global shocks — which seemed a bit outrageous in November — has come true with a vengeance. Russia's currency and economy are in free fall in large part because of oil, with the purchasing power of the ruble half of what it was a few months ago.

Russians will suffer

Russia's currency plunge "will have a severe impact on food prices and other everyday expenses of ordinary Russians," said Aslan Amani, a University of Toronto professor who studies the countries of the former Soviet Union.

Amani says that means the country's economic problems will translate into political problems for Russian President Vladimir Putin.

But at his annual news conference Thursday, Putin said oil prices and the Russian economy will bounce back within two years.

• Vladimir Putin says ruble will recover
• Can Vladimir Putin survive the falling ruble?

“If the price level remains low, companies will stop investing in hard-to-recover reserves and new fields,” Putin said.

“Given a backdrop of growth in the world economy, it will eventually jump, and this will be bad even for developed countries.”

One of Canada's top commodities economists, Scotiabank's Patricia Mohr, agrees.

But she says the rebound in prices will come much sooner. In her year end commodity review released Thursday, Mohr says while oil will continue to fall in December, prices are falling too far.

She says that is simply due to a short-term market technicality. People who borrowed money to bet prices would be higher (called buying on margin) are having to sell to pay off those loans.

"Margin calls on WTI futures have exacerbated the downward spiral in oil prices," she writes, referring to West Texas Intermediate, the North American benchmark price for crude. She insists current low price levels can't continue.

Oil over-sold?

"WTI oil prices below $60 US are heavily ‘over-sold’ and are ‘unsustainable’ at that level," Mohr writes. That's why she says "oil will snap back by mid-2015."

However, not everyone agrees with Mohr.

If the purpose of OPEC's refusal to cut production really is a plan to knock out the higher-price competition, Scotiabank's own figures show that oil prices would have to be considerably lower yet to push a lot of North American producers out of the business. Putin says Russia can sustain production at the $40 US level.

And that takes us to a very different analysis by management consultant Parvis Jamieson in a letter he wrote to the Financial Times.

Jamieson's main point is that if Saudi Arabia is hoping for gain from driving prices lower, any benefit will be slight and temporary. To me, the interesting part is his reasoning why.

Jamieson says that to compensate for the effect of falling prices, lower-cost producers will actually generate more oil, not less, driving prices even lower.

This fits well with the view from other analysts who say that one of the main effects of falling prices will be to force energy companies to become lean and mean, allowing them to produce the same output at a lower price.

Held in reserve

Not only that, but the longer prices stay low, the more high-cost producers will get out of the business.

But unlike previous years when we thought we were running out of oil, this time as prices rise, we have an existing reservoir of proven reserves at each higher price.

"While a reduced price may now sideline some marginal producers," writes Jamieson, "future increases in oil prices would be likely to bring them right back."

And even this excludes the possibility that drowning U.S. coastlines or other economic effects of climate change will exert long-term restraint on the global use of fossil fuels, reducing the demand for oil for the foreseeable future. 

Such conflicting views may not seem very helpful for my friend sitting on his oil stocks.

But if I were looking for a synthesis of views, I would say that even if oil prices rebound, we should not be expecting a sudden return to $100 oil. Not unless there is some other shock in the opposite direction, such as a major crisis in a major oil producer.

Even Mohr's "snap back" in mid-2015 is from a much lower base. She says oil could rise 25 per cent to $70 US. 

So if my friend was willing to hang on to his shares when oil had fallen below $70, maybe he'll keep on hanging on.