We first introduced our CB Capital Global Diffusion Index (“CBGDI”) in our March 17, 2013 commentary (“The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices“), when WTI crude oil traded at $93 a barrel. Based on the strength in the CBGDI at the time, we asserted that WTI crude oil prices have bottomed, and that WTI crude oil is a “buy” on any further price weakness. Over the next six months, the WTI crude oil spot price would rise to over $106 a barrel.
To recap, we have constructed a “Global Diffusion Index” by aggregating and equal-weighting (on a 3-month moving average basis) the leading indicators data for 30 major countries in the Organisation for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia. Termed the CBGDI, this indicator has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by about three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally, as stock prices actually make up one component of the OECD leading indicators).
Our logic rests on the fact that the vast majority of global economic growth in the 20th century was only possible because of an exponential increase in energy consumption and sources of supply. Since 1980, real global GDP has increased by approximately 180%; with global energy consumption almost doubling from 300 quadrillion Btu to 550 quadrillion Btu today. That is–for all the talk about energy efficiencies–the majority of our economic growth was predicated on the discovery and harnessing of new sources of energy (e.g. oil & gas shale fracking). Until we commercialize alternative, and cheaper sources of energy, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that–despite the ongoing increase in U.S. oil production–a rising global economy will lead to higher crude oil prices.
This is what the CBGDI is still showing today, i.e. WTI crude oil prices should rise from the current $74 spot as the CBGDI still suggests significant global economic growth in 2015. The following monthly chart shows the year-over-year % change in the CBGDI and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from March 1990 to November 2014. All four indicators are smoothed on a three-month moving average basis:
As noted, the rate of change (2nd derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been: 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues and Chinese demand came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented many producers from hedging their production.
The second derivative of the CBGDI bottomed at the end of 2011, and is still very much in positive territory, implying strong global oil demand growth in 2015. Most recently, of course, the WTI crude oil prices have diverged from the CBGDI, and are now down 20% on a year-over-year basis. While we recognize there are still short-term headwinds (e.g. U.S. domestic oil production is still projected to rise from 9 million barrels/day today to 9.5 million barrels/day next year), we believe the current price decline is overblown. We project WTI crude oil prices to average $80 a barrel next year. In addition to our latest CBGDI readings, we believe the following will also affect WTI crude oil prices in 2015:
- An imminent, 1-trillion euro, quantitative easing policy by the ECB: The ECB has no choice. With the euro still arguably overvalued (especially against the US$ and the Japanese yen), many countries in the Euro Zone remain uncompetitive, including France. On a more immediate basis, inflation in the Euro Zone has continued to undershoot the ECB’s target. A quantitative easing policy by the ECB that involves purchasing sovereign and corporate bonds will lower funding costs for 330 million Europeans and generate more end-user demand ranging from heaving machinery to consumer goods. While such a policy will strengthen the value of the U.S. dollar, we believe the resultant increase in oil demand will drive up oil prices on a net basis.
- The growth in shale oil drilling by the independent producers are inherently unpredictable. Over the last several years, the U.S. EIA has consistently underestimated the growth in oil production from fracking. With WTI crude oil prices having declined by nearly 30% over the last four months, we would be surprised if there is no significant cutback in shale oil drilling next year. Again, the EIA has consistently underestimated production growth on the upside, so we would not be surprised if the agency overestimates production growth (or lack thereof) on the downside as well.
- Consensus suggests that OPEC will refrain from cutting production at the November 27 meeting in Vienna. With U.S. shale oil drilling activity still near record highs (the current oil rig count at 1,578 is only 31 rigs away from the all-time high set last month), any meaningful production cut (500,000 barrels/day or higher) by OPEC will only encourage more U.S. shale oil drilling activity. More importantly, Saudi Arabia has tried this before in the early 1980s (when it cut its production from 10 million barrels/day in 1980 to just 2.5 million barrels/day in 1985 in order to prop up prices), ultimately failing when other OPEC members did not follow suit, while encouraging the growth in North Sea oil production. Moreover, OPEC countries such as Venezuela and Iran cannot cut any production as their budgets are based on oil prices at $120 and $140 a barrel, respectively. As a result, it is highly unlikely that OPEC will implement any meaningful policy change at the November 27 meeting.
With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.