The Oil Market Has Lost its Mind, Literally Lost its Mind

We are in the midst of a rout and the oil market has literally lost its mind. There is no logic or sense in the market whatsoever.

I am not talking about the price someone will bid to buy a barrel of oil today. There is no rational floor to the price for a barrel of oil that is being delivered right now. Of course there is a lot of hysteria talking about stock levels of billions of barrels, which are actually only about 10% over their normal levels, but there are physical limits which are in sight, so why not bid down the price.

I don't believe the oil price will go below $20/bbl, but actually there is nothing to stop that happening for a short period and I won't think the oil market has lost its mind if that happens. I'll despair, whilst others will rejoice. Not drivers in the UK, who would still pay nearly 78p/litre even if crude oil was free, but in countries where oil consumption isn't taxed to the hilt there might be some rejoicing.

No where the oil market has lost its mind is in the price of the long dated barrel. Now I guess that is actually a pretty thin market, because, who wants to sell a barrel of oil for delivery in 2022 when you are in the midst of a rout. But surely there ought to be buyers, who would bid the price for that up. Seems not. For the price of that barrel has fallen right through the floor in the past week or so.

Here is the chart I have been able to make. It is a slightly tricky one to construct, not least because I don't subscribe to any data services, but also because because the date of the longest dated contract keeps changing through time. So to try and account for that I deflate the longest dated contract value back to money of the day using a 2% rate. That's like taking the inflation element out of the long dated price and seems a bit logical to me.

Now in the last crash when the financial system seemed on the verge of collapse, the oil price fell below $40/bbl but the long dated price never went below $60/bbl before heading up to $80/bbl where it stayed stable despite the spot price soaring to over $120/bbl. You might say that all along the oil business knew the good times couldn't last, that actually $80/bbl seemed a sensible price in the long haul.

Wood Mackenzie see that too, they do an analysis of the long term implied oil price of oil and gas transactions over time. $80/bbl was what the oil industry thought – even up to the last quarter of 2015.

So what has happened since the beginning of last year. Well the industry has cancelled $380 billion worth of projects which were expected to produce 1.5 million bbls per day in 2021 (close to the year that long dated price is at). On top of that, today's low price is going to drive high cost producing assets out of business, and some of them for good. You can shut in a stripper well in the US if the monthly operating costs exceed monthly revenues and open it up again some time in the future, but when you shut down an offshore platform the darned thing is gone for ever.

Yet somehow despite the Middle East being an obvious tinder box we seem to think that operating without any spare capacity in the system whatsoever makes good sense. This is not a re-run of the eighties as I never tire of telling folk. Then there was so much spare capacity in the system it literally took decades to absorb. Now there is none.

We are setting up an almighty spike in prices which will put previous price spikes in the shade and yet today you can buy a barrel of oil for delivery in 2022 for just over $40/bbl in today's money. That makes no sense whatsoever, that's why I say the oil market has lost its mind.