Oil: Crashing to 30 or to 20?

A message to all oil bugs out there: oil broke $40 support and confirmed it yesterday. It's not a rollover effect of the U.S. OIL FUND ETF (USO) described in this article, the rollover happened on February 6. According to that article, USO now holds more than 20% of future oil contracts, which means that it holds shares of future oil contracts exceeding the size of the physical market for Texas tea. So, rollovers are over, and the price is going down. What's next?

I wrote here that I don't see any reasons for oil to bottom now. I also provided a chart of USO with very interesting downward triangle formation. Now this formation is broken down and a break is confirmed. That's a very bearish signal. Granted, USO doesn't represent oil exactly, because the effects of contango and rollover are killing this ETF right now. But together with fundamental data this signal is important anyway.

I think oil might go straight to $30 from here. And if it breaks that level, it can go even lower.

Please spare me lectures on how oil just can't be lower than $50 because it's a marginal cost of production. Many marginal producers sold their current production last year at prices between $100 and $140. They don't care about current price, they sold that oil already. Real marginal oil is coming from the Middle East, and real production costs on many fields there are still below $10.

How long can this low price last? I don't know. Unfortunately, not all oil producers are forthcoming about their hedging levels. One thing is for certain though: the future market is a market of future contracts, not a market of real commodity. If investors start leaving USO and similar ETFs in droves, they can drive prices down much, much more.

As usual, I retain the right to be wrong. But I haven't been wrong about oil since last May.

Full disclosure: at the time of publication author did not have any positions in USO. Positions can change any time.

Comments

[rmenton:]

As always, time horizon is paramount. Entry into USO at these levels for a longer term hold can't be a bad bet. With the production capacity issues around the producing world, any signal that we are making a turn to normalcy can produce very tradable spikes.

Feb 12 08:56 AM

[Jake Berzon:]

Oil is very cheap vs. gold right now. Unfortunately that may mean that gold has to correct to catch up with oil's fall and not vice verso. So, you may be absolutely correct.

Feb 12 09:13 AM

[jse17:]

Alex, now makes Gary Shilling appear as Gary Shandling! Everyone with a scintilla of economic acumen realizes that things are bad! With this said, “Doomsdayers” have their day in the sun periodically and Alex is maximizing his moment in the spotlight.

Hey, who knows, perhaps they will pay us to fill-up our Hummers before the worm turns.

Feb 12 09:14 AM

[deflation r...:]

So, I take it the lesson learned here is to....

Buy a gas guzzler and sell my wife's jewelry.

Feb 12 09:31 AM

[scotty1560:]

oil looks bad and one has to think this is a reflection of the world
economy.. depression seems imminent with long dark days ahead.
Real Estate will be the straw that breaks the spirit of many people..
seeing your home drop 50-80% will certainly take one's spirit..
we live in a new world..

Feb 12 11:02 AM

[ROLEX18:]

Those, who missed big move in Oil can roam, when you are short since 50$ all the world looks nice to you, those who go short now will be taken on short covering rally.
Longer term trend is down, but who of you can survive first significant short squeeze?

Feb 12 11:37 AM

[silverwood:]

I find it very interesting that Brent Crude is trade at a $10 premium to West Texas, WTIC. Another interesting fact is that the DOE has stopped filling the Strategic Oil Reserve as of June 08. I can understand stopping it then due to the raging price increases at that time, but why when we are having a glut of oil aren't they capitalzing on these low prices. I am beginning to smell a rat in the WTIC oil market.

Feb 12 11:45 AM

[Jason Rines...:]

Good article Mr. Filanov, keep them coming and email me someday so we can talk.

I am long oil and nor do I expect a rebound this year, feels more like second half of 2010 and continue to climb each year in conjuction with the devaluing of the dollar. You have done a nice job in coming very close on your oil predictions.

Last year I wouldn't trade oil even though I knew immediately where the IB's discount window fund were going to go. Actually, I got to advise President Bush on niftly little experiment with the Fed in that regard in March to get a benchmark of oil speculation per barrel. But I still wouldn't trade. This year, I am feeling a but more confident it will not be so volatile on the way up. And I do have time to wait for profits, never was much of a day trader. Best of success to all you gentlemen. This time period takes a lot of focus not just on technicals but on Washington (ewww).

Feb 12 04:00 PM

[skeptique:]

"I think oil might go straight to $30 from here. And if it breaks that level, it can go even lower."

True genius that comment! If it descends past 30 it can go lower. Wow!

Feb 13 09:16 AM

[Ferdinand E...:]

Oil might go to $30/b, or maybe even lower, but it isn't important any longer. The bad news that a very high oil price was supposed to impose on the global economy has arrived, although oil might not have had a great deal to do with it. The interesting thing for me is what will happen when the (partial) macroeconomic meltdown is over, by which I mean how will the oil exporters manage that situation in order to obtain what they lost or think that they lost since the oil price tanked.

Feb 13 09:35 AM

[scfranklin94:]

The SPR will stop taking injections to inventory in June, because it will be full. There's no "rat in the WTIC", Cushing is at max capacity! Do some fundamental research and then you might realize that the only way to justify $50 crude prices is for demand to pick up quickly or for the supply to decrease rapidly. Since demand doesn't seem to be rising, the question becomes, "what price will force producers to shut-in?"

What is more likely: that the prompt month of CL (Mar09) will move up in price or that Apr09 will move down when it becomes the prompt? I think the trade is pretty clear.

Feb 13 09:47 AM

[Carl Spackler:]

Good article! Oil on the short term does seem to have a downward track, but I think it is a much better long term play than anything else out there. We have 3 possible economic outcomes:

(1) Economy continues to struggle - In this case, Oil already has a lot of bad news priced into it. Prices will be long term supported by reduced outputs in the major fields. Russia's output is slated to fall by 1% this year and this trend will continue. Other producers have similar problems. In this case Oil could fall $10, but will slowly recover to be roughly where we are now.

(2) Economy Re-inflates and Fed pulls off a miracle - Somehow the Fed gets the engine going and as a major component of production, Oil rises dramatically from its depressed levels.

(3) Economy falls into hyper-inflation or stagflation - Fed engineers the worst case scenario of high unemployment and inflation. Dollar becomes worthless. Oil, being a real asset, rises.

Our three most likely scenarios return two good results and one slightly negative result. Not too bad. For those who consider currency devaluation as a possibility, oil is a safer real asset play than gold. Gold could be considered fully valued right now, so I am wary of buying any more at these levels. Oil on the otherhand looks to be a patient man's play that has a high multiple return.

Feb 13 11:24 AM

[MarkitWacha:]

Does anyone have any data about how long it would take for oil production to ramp up to what it was in July of last year?

If exploration is diminished due to today's (artificially) low prices, and it takes years for new exploration to produce results, it makes sense to redraw the supply/demand curve, in favor of higher oil prices for a given demand.

Not only that, but experience with the equity markets tells us that if something is volatile, it costs more to own. If I were a producer looking at this, I would demand more money to start pumping, just because of the cost of a shutdown, and because of this recent volatility.

Feb 13 11:41 AM

[Pretzel Logic:]

I was short-term bullish on oil as recently as a couple months ago, but the technical damage it has sustained since then has changed my mind. I would now expect oil to have one more downthrust (along with the equity markets) before putting in an intermediate-term bottom. I would think that once it hits the $20's, it will be a no brainer to go long and hold for awhile. But it does look like it needs one more down-leg to complete this crash off the highs.

Feb 14 05:14 AM

[Dave Wrixon:]

The discount of West Texas to Brent is a clear indicator of how much demand has slumped that side of the pond.

This statistic alone is much more reliable indicator or the state of the US economy than any of the lies coming out of Washington.

Feb 14 09:06 AM

[prudentinve...:]

Short-term, anything can happen. In a year from now, either oil will be over $60, or the world will be in such a deep depression that nothing will matter.

Feb 14 08:22 PM

[KJP712:]

A champagne glass just crashed to the floor in Moscow after reading this post.

Feb 14 09:40 PM

[HiSpeed:]

Short term, lower would not surprise me.

In the December 7, 2008 "60 minutes" interview with Saudi oil minister Ali Al-Naimi, he said that their cost of production per barrel was less than $2/per. Yes, $2!

Feb 14 11:52 PM

[Kunst:]

DTO if you think oil is going farther down, DXO if you think the opposite. Check their charts. You will be amazed.

Feb 16 01:54 AM

[squark62:]

kunst: i've been following some of you comments particularly regarding levered ETFs. i like your balanced perspective. here's another case of massive slippage between a long and short fund tracking the same index. the ratio is almost 2:1 in favor of DTO. if anyone wants to short oil down as far as it's fallen, be very careful because that 2:1 ratio would be a killer going in the opposite direction. it would be prudent to hedge a DTO position with some DXO as a pair trade. even if iol goes down further, it's not going to stay low forever and no telling when it goes back higher for an extended period of time. for instance, OPEC is now considering more production cut-backs.


On Feb 16 01:54 AM Kunst wrote:

> DTO if you think oil is going farther down, DXO if you think the
> opposite. Check their charts. You will be amazed.

Feb 16 04:54 PM