Oil slide to $10? Don't scoff, it's happened before: Don Pittis
As some bet on sub-$20 oil, we look for tools to tell us where prices will go next
How is oil like a beaver? If that sounds like a Canadian joke, I suppose it is. But the punch line may help us speculate on what's next for slumping oil prices.
And I use the term "speculate" intentionally. Because whether you are someone trying to choose between a gas guzzler or a fuel sipper as your next car, or whether you are taking a multibillion-dollar bet on next year's drilling plans, it seems we are all just as much at a loss. Even big institutions with the best researchers, including those at Canada's central bank, don't know for sure.
"Despite some promising research at the Bank of Canada on forecasting oil prices, the range of uncertainty around even the best forecasts is very wide," said the bank's deputy governor Timothy Lane this week.
I don't propose to out-think teams of big-headed economists at the Bank of Canada, or the oil giants who should have had the resources to predict current oil prices and now seem just as shocked as the rest of us.
Oil's beaver tale
Confusion over commodity pricing is a Canadian problem going back at least 300 years, as the seminal University of Toronto economic historian Harold Innis told us.
Innis described how the development of Canada followed the historic search for commodities, beginning with the beaver trade.
"They are now falling into bankruptcy because of the low price that furs are bringing," Innis quotes a French official as saying in 1704.
If we think of the economics of the fur trade at all, it is about how the quest for valuable furs wiped out many fur-bearing animals, forcing trappers and traders deeper into the Canadian wilderness. But the market for furs was just as changeable as the modern market for oil.
First Nations people who had become dependent on European goods needed to maintain the supply of those goods even during times when the price for beaver pelts was low. So, contrary to how you probably think markets should work, our earliest Canadian businessmen, the aboriginal trappers, trapped more beavers as demand fell, making the problem worse.
Pumping like mad
The same thing is happening now. While companies big and small cut spending on future projects — including a $6.5-billion US development in relatively low-cost Qatar — the existing producers are pumping (or mining in the oilsands) as fast as they can to keep income up as prices fall.
A report this week from the U.S. Energy Department says oil production will actually rise this year and next.
Companies are cutting costs, but, like the aboriginal trappers, keeping production up. As the Globe and Mail's Shawn McCarthy reported, "supply from both the United States and Canada is expected to grow, and many analysts are forecasting prices will head lower before recovering."
So how low can oil go? Market prices seldom follow a straight line, and despite a partial recovery in prices, there is no reason oil cannot fall further yet.
"On April 1, 1986, [the price of oil] plunged to less than $10 and no, it wasn't an April Fool's joke," recalled John Kingston, news director at the oil analyst Platts. In the late 1990s, despite a decade of inflation much higher than today's, oil fell again to just above the $10 mark.
Betting on $20
Certainly there are traders using a financial derivative called "put options" to bet that oil will fall below $20 US a barrel.
"There has been some light trading in June $20 puts," writes William Watts in Market Watch. But according to experts who watch the market, many more bets are being placed that the price will fall below $30 US.
"In other words, bets on sub-$30 crude oil in June are now 1.7 times greater than physical inventory," energy derivatives expert Stephen Schork tells Watts.
That doesn't mean oil will fall below the $30 mark in June. But it does mean there are people risking large sums of money to bet that it will.
And the further oil falls, the lower the loonie will go as well, although the relationship is not one to one. The Canadian dollar has fallen 10 per cent again the U.S. currency in the last six months while oil has fallen by about half. One economist I spoke to talked about the dollar falling "another five or six cents."
The next obvious question is what happens after the oil price bottoms out. If the current trend continues, the lower prices fall, the more oil companies will cut back on projects while pumping like mad in existing fields. Then once those reserves begin to run out in two years, it is reasonable to think that prices will slingshot back.
Of course, in the long run that's not what happened to the beaver trade. After trapping the critters almost into extinction, eventually fur went out of style to be replaced by other things. Now there is no shortage of beavers and what was once Canada's biggest market has almost disappeared.
In this joke, it turns out the beavers got the last laugh.