Jeremy Grantham Explains Oil Price Decline And How He’s Playing It

Jeremy Grantham, the British-born investment strategist and founder/former chairman of Grantham, Mayo, Van Otterloo & Co. (oversees $120 billion in client assets as of September 30, 2014), has just released his latest quarterly letter on the GMO website. Grantham, whose individual clients have included current Secretary of State John Kerry and former Vice President Dick Cheney, focused on plummeting crude oil prices this time around. He wrote:

The simplest argument for the oil price decline is for once correct. A wave of new U.S. fracking oil could be seen to be overtaking the modestly growing global oil demand. It became clear that OPEC, mainly Saudi Arabia, must cut back production if the price were to stay around $100 a barrel, which many, including me, believe is necessary to justify continued heavy spending to find traditional oil. The Saudis declined to pull back their production and the oil market entered into glut mode, in which storage is full and production continues above demand…

Why did the Saudis choose this route? To drive prices down and force the U.S. fracking industry to put a cork in their operations, Grantham argued. He added:

In my opinion, no economic implosion is likely just yet and, even if the pessimists are right eventually, that crunch era will be ushered in by very volatile and rising oil prices, not three years of abnormal stability followed by a sudden bust! Right now the mad rush to produce fracking oil in the U.S. (one might reasonably say “overproduce”) has given us a global timeout from the inevitable oil squeeze, which in my opinion is now likely to arrive in about five years but which, without U.S. fracking, was already upon us

(Editor’s note: Bold added for emphasis)

So the “inevitable oil squeeze” comes in approximately five years. But a decade out from now, Grantham penned:

Most likely though, beyond 10 years electric cars and alternative energy will begin to eat into potential oil demand, threatening longer-term oil prices….

(Editor’s note: Bold added for emphasis)

Which shouldn’t really surprise readers of “Why We Were So Surprised” when the “crash prophet” revealed:

But right now we have a substantial excess of production, and oil demand is notoriously inelastic to price in the short term – people will not be leaping into their cars to celebrate lower gas prices. But with time they may drive an extra 1-2% percent here and elsewhere and the excess will slowly clear: possibly by mid-year and almost certainly by the end of next year. After supply and demand come into balance, the price initially is likely to rise slowly, held in check by the increasing amounts of U.S. fracking oil that can be profitably produced at each new higher price level. It is this rapid response rate that will make the frackers the key marginal suppliers. This is a sensitive and, I believe, unknowable equation as to precise timing, but this phase will likely end only when fracking production, even at much higher prices, tops out, as it most likely will in the next five years. After that, I believe the equation will revert to the relatively more stable and more knowable one of the 2011 to 2013 era, in which the price of oil will be the full cost of finding and developing incremental traditional oil, which by then is likely to be over $100 a barrel. (In the interest of full disclosure I personally have been and will continue to be a moderate buyer of oil futures six to eight years out, for reasons that should be clear from the above. It should also be clear that such a bet can lose easily enough.)

(Editor’s note: Bold added for emphasis)

Once again, good stuff from Grantham, which you can read in its entirety on the GMO website here (.pdf format, starts page 7).

Christopher E. Hill
Survival And Prosperity (www.survivalandprosperity.com)

(Editor’s notes: Info added to “Crash Prophets” page; I am not responsible for any personal liability, loss, or risk incurred as a consequence of the use and application, either directly or indirectly, of any information presented herein.)

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