Crude Oil Poised for Significant Breakout: Ways to Play

Includes: BNO, OIL, UGA, USO, XLE, XOP
by: Kenneth D. Worth
Crude oil prices seem poised for a significant breakout in 2011. Here's why.

Global production of crude oil and condensate has now reached the levels of production seen in 2005 and 2008, just shy of 74 million barrels per day (mbpd) on a twelve month rolling average of production (Source: (EIA)). Six years of frenzied drilling and elevated prices have not yet produced the additional barrels needed by a growing global economy. Prices remain high despite significant unemployment in the OECD and anemic economic growth.

This is very nearly unprecedented. Only in the 1970’s, after OPEC voluntarily held about 10 mbpd in production capacity off the world market to sustain oil prices at artificially high levels, have we had oil production declining over a six year period. Are we perhaps now at “Peak Oil?”

True, "liquid"s production, often incorrectly referred to as "oil production" in the mainstream media is slightly higher now than in 2008. However, production statistics now being published by the International Energy Agency (IEA) and Energy Information Agency (EIA) include in "liquids production" production of natural gas liquids (NGLs), biofuels and tar sands.

Natural gas liquids includes stuff like propane and butane. Of the over 250,000,000 cars in the US, how many run on propane? Less than a tenth of a percent. Propane production is increasing. Great. Fire up the grill, but when it comes to filling up the tank, we need petroleum, not propane, butane or ethane, which are not readily convertible into gasoline.

Likewise, biofuels, currently counted in "liquids production", are hardly an immediate solution. Global biofuels production is currently under 2 mbpd or less than 2% of total liquid fuel on a BTU basis. (An Flex-fuel Chevy Suburban gets about 11 mpg in city driving on E85 rather than 15 mpg on gasoline.) Even significant increases in biofuels will not make up a shortfall in petroleum production, should there be one in the near future.

Similarly, increased production from the tar sands in Canada is only offsetting declining convention oil production in that country. Indeed, Canadian “liquids” production is flat over the past five years. Tar sands production has resulted in no net increase in Canadian "liquids" production whatsoever. Those expecting continued mining of tar sands in Athabasca to be able to supply the barrels of oil needed by the global economy in the years ahead are going to be quite disappointed.

On the demand side, ten percent unemployment in the US, and significant unemployment in Europe, has significantly reduced OECD crude oil demand over the three years since the 2008 oil price shock. The slack created by OECD economic contraction, however, has been picked up by increasing demand from China, India, OPEC and the rest of the developing world. Now that US and other OECD demand is increasing as well, albeit anemically, due to the economic recovery, the stage has been set for a second global oil price shock. Welcome to 2011.

There just isn't any evidence that production can increase beyond the apparent 74 mbpd limit seen in 2008. Production in most of the world is declining. Kuwait has been in decline since 1970, Iran since 1975, Iraq since 1978. Norway has been in decline since 2001, the UK North Sea, since 1999. Nigeria has not surpassed its 2005 production. Russian production has declined since 1986. The US has been in decline since as early as 1971. Mexican production has been declining since 2005 Even the Saudis seemed maxed out at the 9.5 mbpd reached in 2005 and 2008, with oil at an astonishing $148 a barrel.

Sure there are additional barrels coming from bit players: Brazil with 2.0 mbpd, China with 3.9 mbpd and the UAE with 2.4 mbpd, Angola with 2 mbpd. But increases from these marginal producers are most unlikely to offset production declines from the much larger producers elsewhere in the world which continue unrelenting and unabated.

What happens when declining (or stagnant) global oil production meets up with increased demand from the OECD, China, India, OPEC and the rest of the world? Much higher prices, that's what. It's called supply and demand. The result will be oil near $200 a barrel.

How does one trade this information? Well, there are a number of ways. The usual suspects are energy stocks or ETFs like XLE (major oil companies), [[OIH]] (oil service stocks) or XOP (exploration and production stocks.) Personally, I prefer the commodities themselves. USO and OIL track the price of WTI traded on NYMEX, although the contango of about $5 a barrel six months out will somewhat reduce returns in these investment vehicles. BNO is a better choice as it tracks the price of Brent crude, a more accurate marker for world oil prices and the price you and I actually pay at the pump.

For that matter, the ETF UGA is designed to track the wholesale price of gasoline delivered in New York Harbor, which is sure to rise dramatically given the fact that crude oil production is unlikely to break the 74 mbpd barrier.

For the more speculative trader, close to the money call options on USO with expirations sometime next year are sure to be big winners, given the fact that a second oil shock is in the offing. Likewise, close to the money call options on UGA with expirations next year will produce significant positive returns.

There just isn’t any evidence that 2011 will play out any differently from 2008, now that we are approaching the 74 mbpd limit on production. OPEC ministers several months ago spoke of an $85 target price. Now, we hear talk of $120 as a “fair price”. Let’s face it. OPEC has lost control of this market.
When the price once again hits $150 a barrel, we shall once again be told by OPEC ministers that oil markets are “well-supplied.” Indeed, anyone with $150 will be supplied with a barrel of the stuff.
Supply and demand; gotta love it!

Disclosure: I am long USO, XLE, XOP, USL.