A Tradable Bottom in Oil?

Oil prices continued down again last week. A barrel of crude dropped to under $34 a barrel Friday afternoon. But on Friday evening oil surged more than 10% to close the week above $37.50 a barrel on the NYMEX. It seemed traders realized OPEC could make more cuts in March and oil prices were just “too low.”

Whatever the cause for the spike was, the sharp upturn on Friday could signal a tradable bottom for a couple of reasons.

Jeremy Grantham: “Below 30, I’m definitely a buyer”

The first is the amount of buying interest in oil when it drops below $35 a barrel. In a recent interview Jeremy Grantham talks about a few of the least considered factors when it comes to oil: volatility. In the interview (view video here) Grantham states:

I thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37 in real terms. And I think it has probably jumped again. It will be revealed in 20 years to what level. But my guess is $60, $65, maybe even $70.

But what people underestimate, even in the oil industry, is how volatile the asset class is. In other words, if the trend is $65, it is fairly routine for oil to sell below half, say $30, and more than double, say $145.

And people never get that. So you don't want to be too quick to buy into weakness or sell into strength, necessarily. But it can go a long way. But below 40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.

Grantham isn’t the only one interested in buying oil at the sub $35 a barrel level. There’s a lot of interest. But to go as far as saying “I’m definitely a buyer” under $30 is a very strong statement which will attract a lot of followers.

It’s looking like between $30 and $35 is at least, if nothing else, a temporary bottom.

Oil Stock Indicator

In OPEC: Too Little, Too Late we looked at how oil service stocks can be a good indicator of changes in oil price trends. The stock market is actually a very good predictor of oil prices. Oil service stocks (Oil Service HOLDRS ETF - OIH) tend to lead oil prices (U.S. Oil Trust - USO) for the past few years. When oil service stocks went up, oil prices have followed. When oil service stocks went down, oil prices followed.

As you can see in the chart below, oil service stocks have consistently led the way. Whichever way the OIH (red line) went, USO (blue line) followed.

Now it looks like oil stocks are trending flat to slightly higher while oil prices have fallen. In the past few years, that has been a good indicator of a rebound in oil prices.

Overflowing With Oil

From a fundamental supply/demand perspective, it’s tough to imagine things getting much worse in the short-term.

On the demand side China’s economic problems are well known and U.S. oil consumption is expected to decline for the first time since 1982.

On the supply side OPEC has successfully been able to stick to its quotas and oil inventories around the world are reaching record levels.

Oil stored in Cushing, Oklahoma climbed another 1.7% this week. Now 34.6 million barrels of oil are stored at Cushing. That’s almost three times the same levels in 2004 when oil prices started marching much higher.

On top of that, a few weeks ago Frontline (FRO) reported, “Trading companies are storing an additional 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years.”

In the end, you can make a case for oil over the medium and long-terms. We’ve been through the long and short case for oil before and looked into what the oil bubble left behind. But when we’re focused mainly on the short-term, it’s plain to see there is a lot of interest at the sub $35 a barrel and oil stocks are signaling a rebound in oil prices is on the way. I’m part of that interest and bought on Friday, but I’ll be a willing seller into any rebound.

Disclosure: Long Horizons NYMEX Crude Oil Bull [TSX:HOU].

Comments

[Rob Viglione:]

There's no shame in waiting for inventory levels to tip in the other direction...

Long term it's tough to argue oil fundamentals, so sound investment bets should include long-term maturities. Any short term buying at this stage is speculative, but there's nothing wrong with that...

Feb 16 04:23 AM

[Child Psych...:]

Thank you for the graph comparing OIH and USO, although it would be useful if it were possible to compare to the two for a longer time series (unlikely given that OIH is a relatively recent product.) The stabilization of OIH seems counteintuitive if one buys into the economic collapse = free oil hypothesis.

Feb 16 08:52 AM

[Maxe Paul:]

I would argue that the shorts are covering at low $30 level, and with storage levels surging i would not in any way call a bottom on oil yet. Oil could, and should (in my opinion) go to the low $20 area, given the strength in the US dollar. At some point it will drop through the $30 level, most probably on further weakness from US, Japan and the Chinese economies.

Feb 16 09:04 AM

[da'zman:]

I'd guess that you don't trade the oil markets regularly but even someone with passing interest risking their money should know that there is a big technical in near dated WTI. March WTI expiration is coming up and the differential reached $8 on Thursday.

Feb 16 09:21 AM

[vince v:]

why TSX:HOU vs USL?

Feb 16 09:22 AM

[ROLEX18:]

What you write about, is about volatility of prices or it is called also a bubble, in the deleveraging environment it is very hard to get new money for gambling as simply - there is no money even to buy food or get a social security, medical insurance, pay back credit card debt.
Or maybe in some fairy tale far away land there is plenty of money that can be used to push Oil to 200$ or Gold to 2000$.
How this wonerland is called? $HITLAND
Now you all will witness the power of few money that left to buy Oil, Gold, Diamonds, Copper etc., and you will be astonished how low can this go when leverage is taken out.

Feb 16 11:50 AM

[ValueInvestor:]

The contango is so steep in oil that it'll be very difficult to find oil below $30.

Feb 16 03:17 PM

[misiosnechacz:]

It will be very difficult to push oil in low 20$. It might dip below 30$ but it won't be for long.
Very good point from Rolex18. Prices of basic materials will get reality check and speculation will have very little influence on current prices (compering to 2007). It's more about suply and demand right now. Or I should say suply and lack of demand.
But as long term investment it's worth waiting for another buble. It has to come.

Feb 16 05:51 PM

[bigeasy8:]

I'm not smart enough to estimate the short-term but there are a number of countries with declining production rates which should help support oil prices in the longer term.

The author, like so many other analysts who have gotten excited at times the past few months, fails to mention the impact of manipulation and rolling over of the expiring crude oil contract which has impacted prices over the last few expiration periods (March contract expires tomorrow).

Feb 16 06:36 PM

[beegdawg007:]

Andy.... you are making this too hard. Oil will be at a tradeable bottom only when the 20 to 35 day MA start to move up. That's how I knew it had topped and that's how I'll know when it bottoms. This is a world wide commodity, not some penny stock. Don't try and "predict" what will happen. Simply watch to see what "is" happening. And, as anyone can see, oil has not yet bottomed...

stockcharts.com/h-sc/u...

Feb 16 06:49 PM

[beegdawg007:]

That last chart did not work. Lets try this..

finance.yahoo.com/echa...;range=5y;indicator=em...

Feb 16 06:52 PM

[Conan the B...:]

As far as I can garner, between the worldwide decline in Manufacturing and the approximate 50% decline in worldwide auto production, we are in a prolonged period of Oil glut.

I do not think Opec can cut enough by itself to stabilize the market. It needs support from the other producers.

Everything energy intensive is slowing or even stopping.

The Obama Plan will not do anything in 2009. It is geared to provide the greatest stimulus during or pre-election years.

At least, that's how I view the Plan.

Feb 17 12:07 AM

[doubleguns:]

The glut can only last so long as drilling new holes will stop and old ones dry up. Mexico production is down and so are others. Eventually the supply will be the driving factor in a increasing price.

NO I do not know when that will be but long oil at 30 or less seams to be a sure bet if you have at least a 2-4 yr time line it could be very productive. Question is could you be doing something else with that money in the short term and do better.

Feb 17 01:10 PM

[User 358966:]

This is a very good article. I think oil will go down to 27 or so, but don't think it will stay below 30 for long.

Too many countries are depending on oil to be at a certain price, $50 on average, to maintain their economies. Most are hedged through the end of the year, but if oil stays at these levels certain dictators will do whatever it takes to drive the price up.

We also have to look at the strength of the dollar. Oil likes a weak dollar and with all the TARP packages coming out, we will soon get it. Once inflation kicks in, the price of oil will start to rise.

We may have to be patient for the next 12 months or so, but I believe an investment at these levels will be greatly rewarded with some patience.

Feb 17 06:42 PM

[ValueInvestor:]

What people don't realize is that only the near term price is $35. Look at Dec 2009 futures, its trading at $46 and Dec 2010 is $53. So for prices to stay flat at $35, the price contango has to continually decline at the same rate as the near contracts expiring. Only a huge move will put the long dated stuff closer to $30.

So if the near contract gets below $30, it will quickly expire and the new one will be higher. Its tough to invest in long-term oil because you can't find anything close to $30.

Feb 18 06:07 PM