Oil prices are so not surprising

We don’t usually use this space to comment on swings in the commodity markets, but the recent and ongoing plunge in oil prices is hard to ignore. For people in the energy industry, the news is generally bad, whether they’re in petroleum or its alternatives. For most others, the news is good, akin to the economic tailwind provided by a broad based tax cut.

For people, like myself, who work in the “uncertainty industry”, this is a teachable moment, albeit a slightly uncomfortable one since so many DPL customers are on the selling end of that plunging price. I continue to be surprised at everyone’s surprise. Prices are not even at historic lows, and while their fall has been swift, that’s the way markets often work.

Overconfidence bias is a stubborn thing, and people are very quick to anoint present circumstances as “normal”, and anchor on the average over the past (say) five years, as if nothing interesting or relevant happened before that time, and nothing is about to change.

In the early 2000’s, pre-Syncopation, I worked on several consulting projects for one of the international oil majors. We were using real options techniques as part of the economic evaluation of some large capital projects. At that time, OPEC’s official policy was to keep prices in a band of $22-28/bbl, and for several years they were generally successful in doing so, before booming demand eventually convinced them that the traffic would bear more. In addition to various probabilistic approaches, the client liked to do a deterministic stress test with a reference price of $12/bbl, flat. Mind you, that was a no good very bad scenario, but it was considered plausible at the time, given the prices seen in the mid ‘80’s glut. Less than 15 years ago, prices in the $20’s were considered normal.

No, I’m not shorting oil in my 401k, because there are plenty of plausible futures that would have normal prices well into triple digits. Consider Saudi Arabia, which accounts for 13% of world production, and is an old school monarchy, unpopular with its people even as it pampers them with generous social spending. Just how long is that going to last, and who’s next, the pro-westerners or the Islamists? I don’t even need to say “Putin” to visualize $200 oil. Estimates of the present oversupply differ, but even the highs put it at less than 2%.

I’m not an expert in oil prices, but I’ll stick my neck out and say they’ll remain in the range of $10 to $250 for the next few years. You won’t have to look far to find experts and non-experts making more confident predictions. See if you can talk them into giving you 10-to-1 odds on the price staying in their band.

Uncertainty is the old normal and the new normal. Notwithstanding the breathless talk on CNBC and the like, veterans of the energy industry recognize this as garden variety volatility.