Fundamentals Don't Support Oil at $55-60 a Barrel 43 comments
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The recent run up in oil prices to near $60 per barrel is both surprising and concerning to me. While oil pulled back some last week, it still trades in the $55-$60 range. It is dangerous to make a near term directional call on oil prices. Doing such is more speculation than investment. However, the latest report called the Short Term Energy Outlook (STEO) released last week by the U.S. Department of Energy (DOE) paints a picture of falling demand, stabilizing production, and building inventories. To me, the data compellingly supports a correction in oil prices in the coming months. Even $55/barrel oil is high in the presence of falling demand despite all the talk of “green shoots” in the economy.
There are a few basic arguments supporting the rise in oil prices:
- U.S. deficit spending & Federal Reserve policies are flooding the world with dollars, devaluing the currency which will ultimately lead to inflation.
- Low oil prices cause new drilling projects to be delayed or cancelled, ultimately shutting in capacity.
- OPEC has been steadily reducing capacity to bring supply in line with demand.
In the long term, these may all be true. However they each play out over very different timeframes. For example, decisions to drill new wells and bring new production online can take multiple years to carryout. It is true that the U.S. Treasury is issuing debt at an astounding rate but even the most recent numbers last week indicate that inflation is at zero. Some day, all this money will flow through to the economy and spark inflation. In the meantime the world is awash with excess oil.
The above chart from the DOE STEO report shows stocks of crude oil inventories to be far outside normal range in terms of number of days supply. The total inventories in the OECD (industrialized countries) has not been this high since the mid 1980s.
Rising oil inventories were understandable in the face of falling prices and/or falling supply. However, it is not so logical in the face of increasing prices which has been the case since the beginning of 2009. The most recent spike in inventories near this level was the fall of 2006. At that time crude oil prices corrected more than 20% from their Aug ’06 high above $75/barrel.
The summer of 2006 was the last time that global oil supply (production) and demand (consumption) was roughly in line at just over 84 million bbl/day each. The period that followed (shown below) was a consistent period of demand outstripping supply due to global growth. This gap in supply launched a run up in price for crude oil that lasted until July 2008, about the time supply caught up to demand.
Supply stabilizing but demand is still falling. The cross over point in mid 2008 was reached partially because of increased supply but also because U.S. demand consumption, which had peaked in December 2007, began a decline that has yet to cease. Since that period, the world has been in a steady decline as one region after another throughout 2008 peaked in their consumption of energy. Supply has been curtailed, mostly by OPEC output cuts but demand has continued to fall faster.
As reported last week, OPEC supply is no longer falling yet the demand outlook from the International Energy Agency continues to weaken. Oil producers once before tried to hold production constant last November in the face of falling demand and rising inventories. What followed was a sharp drop in crude oil prices from the low $50/bbl range to a recent low of $32/bbl in the final week of the year.
U.S. energy demand is still declining. The chart above shows that U.S. consumption of oil is still declining. The same is true for most industrialized nations. The sharp drop last September was followed by a recovery in October leading to a view of stabilizing demand through December. However, the view of the first four months of 2009 paints a picture of continued decline.
As shown in the first graph, the DOE forecasts inventories will drop starting in June. Whether this is believable depends on whether they are forecasting the correction to be driven by a decrease in supply or an increase in demand. If the correction is predicated on an increase in demand, where is it from?
A look at the supply side of the equation (graph above) shows few surprises. Since the middle of last year OPEC countries (mostly Saudi Arabia) has gone from providing excess capacity in 2008 to reducing capacity this year. Going forward though, this OPEC reduction is expected to moderate. Additionally, the argument that low prices have caused producers around the world to stop producing has yet to be validated. Production tin the U.S. and the former Soviet countries is on the rise. Only in Mexico and the North Sea is production presently in decline.
It is plausible that Mexico and the North Sea are suffering from reduced capacity but the same is not true for OPEC. The data as tracked by the U.S. Energy Department show that, while the OPEC production has been reduced by three million barrels per day, the production capacity remains intact to soak up demand when it returns.
It turns out that the DOE forecast of a near term inventory correction driven primarily by demand growth returning as early as June. The demand growth would be driven only a small amount by China (which is happening) but rather improvements in Western Europe (less plausible) and a return to robust demand in rest of world. Asia other than Japan and China is holding up well but is it healthy enough to provide demand growth that is twice that of stimulus-driven China?
So, if not demand, what is behind the recent run up in prices? We are, in the form of mutual funds and ETFs. Investors have been heading back into commodities (particularly oil and gold) since March when the Federal Reserve began quantitative easing and the U.S. Administration began describing trillion dollar deficits for the next decade. However, unlike gold funds that often buy bullion and physically store it, index funds place bets through futures contracts but that must be closed out before taking delivery. Stories abound of oil stored at sea by the tanker load but more often than not traders and funds cancel out of contracts about a month ahead of delivery.
According to a recent study by the CME Group of dynamics of various trader groups on commodities markets, index funds tended to enter the market 75 days prior, exit 25 days prior. Then contracts are rolled over to the next month. Eventually, though, this can have the effect of bringing too much oil to market and, if OPEC has stopped reducing production, a price correction is the only way to remedy this.
Therefore last Friday, I took a short position in oil. There are a number of ways to do so. About as many ETFs in the energy space bet on declines as bet on oil price increases. These include PowerShares Crude Oil Short ETN (SZO), PowerShares Crude Oil Double Short ETN (DTO), and Direxion Daily Energy Bear 3X Shares (ERY). These have single, double, and triple leverage respectively. In my case, I took a slightly different tack by buying at the money puts of double long ETF: Proshares Ultra Crude Oil ETF (UCO).
The reason for this position is that leveraged and inverse ETFs erode in price over time due to their mechanics of daily rebalancing. Thus, by buying the puts on a long ETF, I am taking a short position on both near term oil prices and the construction of leveraged ETFs. Please see this article on the issues with leveraged ETFs.
I don’t describe this short term trading position in detail because I am vain enough to believe people following suit will help my position. I am quite clear I don’t reach enough folks for that to happen. I do, however, believe that the analysis can be helpful as it shows: 1) fundamentals suggest oil prices will head lower in the near term, and 2) hedges against inflation are difficult to get just right. ETFs are useful but they have their problem over a longer period. The switch from governments fighting deflation to fighting inflation could happen this year or maybe not until late next year. Long term I am bullish on oil (and other commodities) but only when there is evidence that demand is increasing, or at least no longer falling.
Disclosure: Short oil through put options (UCOSI) on the Proshares Ultra Crude Oil ETF (UCO).
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This article has 43 comments:
Well said. 'We have met the speculators, and they is us.'
While I suspect the author is correct, just to play devil's advocate, in answer to the headline - they didn't really support oil at $150/barrel, not so long ago, did they? In the short term, all sorts of wackiness can ensue.
just to add to the speculation debate, last wednesday, the new CFTC Chairman, Michael Dunn, was quoted (link below):
"We were told to look at significant price discovery contracts and we have been doing that,"...noting that preliminary reports suggest "it was much larger than we originally thought" and that staff was "surprised" by the preliminary findings."
This, in no uncertain terms, is Dunn admitting that ICE contracts did in fact have an effect on oil prices...this, in direct contrast to what the CFTC reportedly this time last year. Funny how that works.
Link: www.easybourse.com/bou...
--R
Respirate, you haven't Seen "the bottom end of consumption"! LOTs of commercial use (trucks, trains, ships) that won't be used as unemployed folks don't buy stuff. While I don't doubt turmoil will occasionally shock prices up, I suspect prices will be depressed as long as the world economy is.
Oil is a limited resource. If you see this and you are the leader of a country or a company that needs oil to run, what do you do? You buy it when it's cheap and you store it. Countries and corporations aren't doing this yet - except for China, which is starting to - but speculators are. Sooner or later the bigger players will realize that they need the oil and will buy it from the speculators. As supply goes down year after year it will be more important to have reserves. Large inventories could be around for years as their importance is recognized.
Short term the price of oil is hard to predict. Long term oil is going up.
Oil will go out of control, as will commodities in general -
On May 19 12:45 AM sickofthehype wrote:
> Precisely. The market in general is not trading on 'fundamentals',
> but regardless it's going up too. Oil is pegged to the dollar, which
> is about to sink like a rock, and it's all been planned that way.
> The overkill in stimulus will lift oil to new heights, and nothing
> about it will be 'fundamental'. It's inflationary, and there is absolutely
> nowhere oil and commodities will go but sky high. Get ready.
On May 19 01:24 AM curious cat wrote:
> the developing nations don't have to follow the same path to properity
> that we took. they can leap frog on our innovations and come in a
> few generations of technology later. don't expect all those consumers
> to consume as much of the same stuff we did.
Of course China is stock piling on every commodity - bottom fishing, diversyfying its investemenst away from the $. It is good strategy for China, best utilization of their money.
In my opinion the only green shoots are Wall Street created illusions.
The only speculators I saw was on the short side, driving oil to an unsustainable price in the 30s. All this accomplished, besides allowing some speculators to make money, was to force even more energy projects to shut down.
Who said anything in these markets has to follow logic ? Bubbles get created via speculators who create momentum and then a heard of naive followers make the bubble bigger. Like in Vegas, if your going to play long enough, the house wins it all ! So the trick is to take some profits off of the table. The unfortunate part is that many times the public suffers because of the "games" that drive commodity prices all over the place. How many lives and familes have been hurt/destroyed because of what sepculators have caused ? But, things won't change, nonething to cry about. Simply use your brain and try to do the best for yourself !
On May 18 05:26 PM Jasper M wrote:
> "So, if not demand, what is behind the recent run up in prices? We
> are . . . "
> Well said. 'We have met the speculators, and they is us.'
>
> While I suspect the author is correct, just to play devil's advocate,
> in answer to the headline - they didn't really support oil at $150/barrel,
> not so long ago, did they? In the short term, all sorts of wackiness
> can ensue.
I hope we aren’t getting into the trade of last summer which killed this country. Where “investors” (read speculators) shorted the dollar, bid up oil then shorted the market (predicated on the idea that if you cranked commodities it would kill the consumer and the economy therefore making the dollar shrink father and oil more expensive) and took to just being a pariah on the consumer to make a buck. It all became a self fulfilling prophecy.
China is not "taking off" again. There exports are in the toilet and they have not been able to resituate internal demand. Talk about "don't believe the hype".
Oil is on sale right now and will only stay low temporarily. Shorting oil in the near term may prove profitable, but I doubt you will do more than break even, especially in the traditionally higher summer months. Has everyone shut their eyes to the Chinese? China is dealing with Brazil right now to lock in oil contracts for the future of their upcoming production. There economy is going to recover quicker than ours; they will be like the U.S. in the 1940's and will eat up the oil supply. The Afghan war is escalating now with more intense fighting with Pakistan, and our buddies from Iraq will be killing each other again over control of their most prosperous natural resource, oil, in no time. f-18's, Bradleys, helicopters, armored personnel carriers, ships don't run off of butter-scoth and hope. Green energy has proven more expensive to produce than it is worth, and the majority of Americans back green energy in theory, but can't afford to pay higher costs for less output. There aren't any 'green' 18 wheelers that I have heard off that can haul produce cross county. When our economy recovers, whether it be 6 months or six years, will push demand right back to where it was, but the world's population isn't getting any smaller. The Chinese will continue to grow their economy and we will be right back to where we were. $140 dollar oil will sound cheap. In addition, there have been a number of discovery projects cut short or completely canceled that cannot run or turn a profit with oil below $80-90/barrel.
On top of all that, you have good old Obama printing money like it grows on trees. Our mega-deficit will tank the dollar and make inflation go crazy, like some people believe. Oil, which is priced in dollars, will rise dramatically in the next few years due to this fact alone. In summary, good luck shorting oil at $60 dollars. I will be skipping to the bank in 2011 when oil is back up over $100 because it is on sale right now and may not get this low again for decades.
Jim
On May 18 06:25 PM Nathaniel C wrote:
> The author argues that the fundamentals dont support $55-60 oil.
> The problem is that oil is not trading on fundamentals. It seems
> that everytime oil inventories rise, speculators see this as a buying
> opprotunity and bid the price higher.
Demand and Supply set the price, Supply is in fact falling, Demand is Growing, do not short Oil.
www.nber.org/feldstein...
I'll even use a simple example...i denominate the value of my shoes in dollars. Now when the dollar falls in value, that means that my shoes go up in price? No.
A commodity, such as oil, is an object with no future cash flows...so you can substitute most anything in that example (hats, ipods, underwear, you name it).
the dollar/oil meme needs to die. notice that the $/oil correlation was nonexistent during the 90's and prior to exempt commercial markets, which today trade huge chunks of daily volume. that's not a coincidence.
It is forming a bearish expanding flat with a price target of $62+. That price target has been expected long before the rally went half-way through. At least by those who know how expanding flats work.
It is bearish so the next run down target goes to $32 or lower.
What can cause the sell-off in oil contracts?
China's 7 months of rally is just about done already. It will need a pullback lasting more than 7 months thus presuring the whole Asian continent into a sell-off.
US and European stock markets are also facing significant headwinds on their weekly and monthly charts after the rally off March 2009. They are now bound to start the next leg of sell-off if not a temporary pullback.
Oil is going to get hammered in the next following months.
Now, deleveraging is still going on and it has years, not months further to run and there is no strong sustained economic recovery in sight anywhere on the globe. That means that over the next 12 months sudden spikes in oil demand are very very unlikely. supply is falling and the speed will accelerate, but storage and production reserves of OPEC are sufficient to balance that.
what gives? imho, the most likely scenario is that oil will trade within a range of 35-70 dollars for the next year and I think the author's strategy makes good sense ( though I would rather chose january 2010 options instead of July 2009). given the way these leveraged etfs are structured, he may make money on the position even when oil stagnates. heck, if the oil market were to experience daily fluctuations of 2-3% over the next few months while keeping his current levels, overall, you could make a ton of money shorting both the ultra short AND the ultra long etf.
...the solution? stop driving or give up your car if you really don't need one. Add up your savings in insurance & car maintenance.
when it comes to oil, your fundamentals must include
- lunatic dictators
- even more scarce fields
- oil addiction (battery cars? so what?)
- wars, wars and more wars.
- china, india, brazil growth
add to this, all of its variants (almost endless)
and you will get the result
oil = way over $60.
I agree with your philosophy, but when GS is on a mission, manipulation sets in and here we are..