Crude Oil Fundamentals Bad For Price

Includes: DBO, OIL, OLO, UCO, USL, USO
by: Roman Chuyan, CFA

Fundamentals for crude oil price have been fairly weak for a while, as we've highlighted here on May 15. This short article updates developments that occurred since May - the Middle East premium that drove the price of the WTI contract above $100, which is now removed, and the new "carbon bubble" perspective advocated by Al Gore.

Investors bid oil up above $100 in the July-September period due to concerns about Syria using chemical weapons and the potential U.S. military strike against the Assad regime. These concerns have now receded, and international inspectors confirmed on October 31st that Syria has destroyed all of its declared chemical weapons production facilities, meeting the first significant deadline in the process. With the Middle Eastern "premium" out of the picture, fundamentals will now determine the new price level for oil -

Demand for energy resources has been soft in recent years due to slow global economic growth. In addition, the general drive towards energy efficiency has been gradual but steady, including more natural-gas power plants, efficient appliances, fuel-efficient cars, and 100% electric cars.

On the supply side, North American production is starting to accelerate, made possible by fracking technology employed in the U.S. and by the Canadian oil sands. The International Energy Agency even expects a North American "supply shock."

"The supply shock created by a surge in North American oil production will be as transformational to the market over the next five years as the rise of Chinese demand has been over the last 15."

the IEA said in its annual Medium-Term Oil Market Report in May-2013. The supply is led by U.S. light oil (driven by technologies applied in North Dakota) and by Canadian oil sands.

This will ease a market that was relatively tight in supply for several years, which in the past no doubt contributed to elevated prices. The IEA forecasts that worldwide liquid production capacity will grow by 8.4 mb/d - significantly faster than demand, which is projected to expand by 6.9 mb/d.

(Click to enlarge)

Another perspective was publicly highlighted by former Vice President Al Gore in the past three weeks. The perspective has traditionally been "environmental" (and largely ignored by investors) but is now moving to the fore of investment and risk management. Gore argues that the world is in the midst of a "carbon bubble." According to him, the estimated $7 trillion in "carbon assets" (i.e., fossil-fuel reserves and plants) on the books of energy companies are held at inflated values because only a portion of them can be sold and burned. Whether or not you believe in climate change, Gore is a voice that investment managers should reckon with. A co-founder and chairman of Generation Investment Management and a senior partner at Kleiner Perkins, he advises major university endowments and pension plans to avoid these assets.

Oil price dropped decisively in October - likely due to the removal of the geopolitical premium - but supply-demand fundamentals should determine price in the medium- to long-term. Tight supply helped oil price stay in a three-year range of approximately $85 to $105 for the WTI contract. If IEA's projections are accurate and supply growth exceeds demand by about one mb/d this year and next, it is likely that oil price will drop below $85. In the short term, we think that we will see a move to around $90 rather quickly, similar to what happened to gold in the first half of the year.

Given this short-term and medium-term outlook, we do not recommend that investors have any exposure to crude oil as a commodity, such as in the form of oil-linked ETFs (USO, USL, OIL, DBO, OLO), and especially leveraged long oil ETF (NYSEARCA:UCO). We also think that investors should look hard at broader commodity ETFs which may have a significant portion of oil - see the lists on SeekingAlpha's Guide to Commodity ETFs. More aggressive traders who, after doing their homework, agree with our thesis, may want to profit from the decline in oil by buying near-term put options on oil ETFs.

Disclosure: I am short USO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. I am long Put options on USO.

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