The Ghost of Crude Oil Futures (Part 2/2)

Happy New Year. Welcome is the psychological reset of the scorecard to our portfolios. Most investors are eager to pretend that the new year will begin with a clean slate, with fresh money and no losses glaring at them from half-opened portfolio statements.

The daunting truth is that, for the most part, investors large and small have experienced devastating losses this past year. Remarkably, this actually bodes well for new investors (as well as the market in general) because although little has actually changed from December 31^st to January 1^st, psychologically there is more optimism due to the sheer desire for something to go right for a change. And, as I have stated countless times before, psychology means more to actual market direction than earnings ever will.

Alas, my focus this week will be a continued analysis of the crude oil market in terms of price barriers, the possibility of messing with a balanced market, and what kind of ride we’re in for ahead. All the same, this “fresh start” psychology will play a role in the future of oil… well, futures.

Taking a fresh look after a rotten year

As previously mentioned, many investors will be peering into the market in January as if they had not been watching it in despair over the past fourteen months. Doing so will reveal the lunacy that occurred in the short-term oil bubble and the ensuing collapse.

Let’s look at the prices crude oil has trespassed over the past nine or ten years:

As you can see, leading up to 2007-2008, there were major support/resistance levels created around $30, $50, $60, and just over $70. During the run up in the past couple of years, it tore through new highs, peaking at $147. It then proceeded to collapse in six months, crashing through every price level as if it did not exist at all.

We all know that, during times of extreme duress, markets tend to overshoot prices in either direction. This has a rubber band effect that can be difficult to gauge. That being said, I propose that we concede that the run oil made to $147 per barrel only six months ago was part of a panic bubble, feeding off of fear and speculation, greed on the part of oil companies, and uncertainty regarding our foreign policies and predicaments. Afterwards, the falling knife (or more accurately, running chainsaw) had not found a landing spot until it touched just above $30 per barrel only weeks ago.

Ladies and gentlemen, demand may have subsided to some degree. But the fact remains that from a technical perspective, there has essentially been no bounce to speak of since this landslide began.

Hordes of investors are going to be looking at this information and realizing that the screaming oil prices of 2007-2008 have been followed by just as much insanity as it overshoots to the downside. Short covering, re-positioning, and speculation alone should trampoline these prices back to the $50s at least in the near term (by “near term”, I am referring to a time period of a couple of months).

I am not selling my position yet.

What if we were wrong about demand?

Matthew Simmons, who I quoted in last week’s article in his recent interview with Fortune, believes that demand has not fallen to the extent that prices are reflecting. Furthermore, he states that $40 oil (much less $30 oil) is so devastating to oil-based economies that OPEC will actually continue to make supply cuts as necessary. On top of this, companies in the oil and gas industry are cutting production (and hence supply) for the very same reason.

Here is the problem: there is no way of collecting precise, reliable demand data in such a short period of time. So, we are essentially guessing in terms of where we think demand actually is and how this should affect prices.

What happens if we’re wrong?

Is this not so conceivable? Damn near everyone, including myself, has been wrong at some point in the past year. Are we so arrogant that we believe we can correctly determine the short- and long-term oil demands of both individuals and businesses throughout the world to the point where we can determine an accurate price? I doubt it.

So, if the markets do not have a great deal of flexibility in them, and we are cutting supply in a market that is actually relatively balanced, we have a supply/demand disaster in the making. It is entirely possible that excess supply is merely a perception, partially due to the record-breaking drop in oil prices, in which case we are depleting an already (historically speaking) low stash of oil.

This will send prices higher, and this will not occur slowly.

A final word on the future of oil

Regardless of what is happening in Iraq, Gaza, Russia, or the Moon for that matter, a couple of simple facts remain.

Number one, that there are far too many cars on the road for the world to suddenly relinquish its thirst for oil. At my local Jiffy Lube, I was unable to procure a cold fusion converter for my car for $99.99, along with a lifetime supply of hydrogen.

Secondly, it does not rain oil. Aliens do not deliver oil every other February, and crude is not able to be converted from old tires or grass clippings. There is a finite supply of this resource, and that will not likely change. Furthermore, it does not get cheaper to reach what oil we have left as time dwindles on.

We are no longer at the point of speculation, we are at the point of common sense. Perhaps there’s not enough common sense left in the world to make me correct on this issue, but I’m betting a lot of my own money that I am.

Cutting into a balanced market… or making too many production cuts could snap the price of oil back up to levels unknown.

What happens when demand “comes back”?

Well, if you think the oil companies are jumping for joy as the price of their product falls through the floor, I don’t know what to tell you.

Moreover, if you think that they’re going to do us any favors by increasing production (and hence supply) if the price creeps up, you’re equally crazy.

Disclosure: No positions.

Comments

[Ferdinand E...:]

I believe that oil based economies will continue to make cuts, but I don't believe that $40/b oil is devastating to their economies. Of course, some of them are prepared to argue that oil at $100/b is devastating.

I also agree completely with the last 6 paragraphs in this article, and if the author is wrong it doesn't make any difference. What he says corresponds to the structure and logic of the oil market as I understand it. We can only hope that our political masters get the point.

Jan 04 08:00 AM

[odessa88:]

It will be interseting , one year from now to see who was right

Oil ,Gold, smallcap ETFS, or the S&p 500.

I am in the Oil camp

Jan 04 11:29 AM

[freefall51:]

The best way to bring the oil price down is to buy USO which I did on Friday.

Jan 04 12:07 PM

[User 330746:]

is USO the best play to hold OIL long term ? doesnt USO have a relatively high maintenance fee of .5 + %,
I think buying NYMEX OIL futures are cheaper? any other ideas?

Jan 04 12:28 PM

[Ishortyou:]

Guys isnt time to tune up our brain washed fossile fuel only driven cars to new age technologies? I think technology is what makes revolution in other ages.

Jan 04 02:48 PM

[UPOIL:]

I have been buying the DXO PowerShares DB Crude Oil Dble Long ETN



On Jan 04 12:28 PM User 330746 wrote:

> is USO the best play to hold OIL long term ? doesnt USO have a relatively
> high maintenance fee of .5 + %,
> I think buying NYMEX OIL futures are cheaper? any other ideas?

Jan 04 03:36 PM

[Kunst:]

I agree with your thesis. During the spring/summer, we were told that the huge run-up in oil prices was due to supply and demand. I said, no way it has changed that much in this short a time. Now we have the opposite swing of the pendulum. Yes, people are driving less, but how long will that last with gas at $1.50 a gallon? Yes, the world economy is throttled down, but does anyone think that's a permanent thing? All indications are that max potential oil production is at, near, or past its peak.

We often talk about "demand" for oil, but this is meaningless unless the price is specified. The demand at $5 a barrel is huge compared to the demand at $500 a barrel. With population and affluence increasing in the developing world, "desire" for oil can only go up. Production is being cut back now, both by OPEC and because unprofitable wells are being shut down. In addition, low prices certainly aren't fueling the urgent push for more exploration that we will need to replace ongoing drops in production from current fields. And if that isn't enough, dollar weakness from massive stimulus spending would also push oil prices up. Only an ongoing recession/depression can delay these forces, and it would only be a delay, not a fundamental change.

I think oil prices have overshot to the downside. I am long DXO (after some profit taking on Friday).

Jan 04 04:28 PM

[Commodity B...:]

Interesting article

You're point about the oil market prices rising rapidly misses one key point however.

1. Companies will scale back on long term projects, not ones where they have already invested in infrastructure. As a result, most of the new production that has been invested in should get built b/c of the amount of money already sunk into those capabilities.

2,. When OPEC cuts production, they increase spare capacity. As a result, when demand starts to increase, OPEC has spare capacity that can handle the new demand. This acts as a damper to rapid price increases. (Spare capacity is now at a healthy 3 million barrels/day)

Jan 04 07:08 PM

[oiler1930:]

Remember that a futures contract is a wonderful two-edged sword. It is not a purchase, and the small margin requirement can be wiped out in a hurry. For a 1,000 bbl contract, a $1 change in price is $1,000; with $5 swings in daily trading, you can get wiped out in a trice if you can't meet a margin call. NYMEX margin is about $8,500 a contract.

The comment about fees for USO is germane, but there is no counterparty to devour your investment, only price action. buying now may be safer.

Jan 04 08:05 PM

[scotty1560:]

It seems like the world is relatively peaceful right now...one would imagine
some geopolitical testiness if economic struggles continue.

One expects people might drive a bit more with the low prices...I will...

A few years down the road the next spike could get nasty without an ongoing
pipeline and exploration......I see water and energy, primarily oil as two evils
of the future. California, Phoenix, Atlanta are going to have severe water shortages and eventually pay dearly to Canada or turn into ghost towns.
The whole equation is getting out of control..unsustainable imo.

Living in Florida, I can say the hurricanes seem to get more intimidating by
the year...a direct hit seems only a matter of time in the gulf...call it a
cycle..el nino..warming..these storms are not going away anytime soon.

Agree with the comment regarding the position of the dollar..it's a factor.

Jan 05 12:39 AM

[Coal Monster:]

I'm sitting on the sidelines waiting to buy some steel and natural gas related stocks...and I would like to buy when the DOW goes below 8500 and/or oil goes below $40...

Do any of you think this will happen in the next two weeks or will the DOW stay above 9000 and oil above $40?

Jan 05 02:21 AM

[scotty1560:]

this little move in oil made my week....

I was one of the preacher's saying buy USO at under $30...
looks like a bottom for a while at least...would take another round
of collapse to break those lows...just my opinion of course...

oil made a nice little move...best to not chase it...see if you can't knock
5 points off...getting a little hyped with the Gaza activity...or scale in
with 6-10 positions...that's what I like to do.

Jan 06 01:47 AM