Anticipating a Decline in Crude Prices: Shorting Oil, Silver ETFs Should Be Profitable

Includes: OIH, SLV, USO, XLE
by: Steven Jon Kaplan

There has been a lot of talk in the media regarding why crude oil prices will rise because of tension in Libya and elsewhere in the Middle East. The usual analysis will mention something about potential supply disruptions due to uncertainty about who is or who might be in charge, and what the future might hold for the region. The assumption is that, one way or the other, total supply is going to be curtailed, which will naturally lead to higher prices.

However, those who are reasoning in this manner have not considered the true implications of recent developments in that region. For decades, governments in the Middle East, especially those of major oil-producing nations, have been able to conspire to keep total output restricted, in order to ensure artificially high prices. There is no question that Middle Eastern countries could increase their production of crude oil, as is evidenced by the much higher daily production which existed when prices had peaked above 147 dollars per barrel in the summer of 2008. As long as governments are run by a tiny cadre of wealthy individuals, they are perfectly happy with low annual output. They don't need any more money for themselves, and by keeping oil prices high, they are ensuring continued outsized profit margins.

During the past several decades, oil producers worldwide consistently generated higher earnings than nearly all other equity sectors, because there were only brief periods in which prices were so low that they either caused actual losses from high-cost production facilities, or mandated shutdowns of unprofitable rigs.

During the past several months, the most intense and consistent selling of their own shares by top corporate insiders has been in energy subsectors including coal mining, oil production, natural gas, and related assets. It is clear that those who are most knowledgeable about the industry, including the situation in the Middle East, are expecting lower prices rather than higher ones. The more that you study the likely political implications, the more obvious becomes the likely denouement.

There is no way to know for sure whether or not there will be actual democratic governments in some countries like Egypt, Tunisia, and Libya, or whether one form of autocratic or oligarchic rule will simply be supplanted by another. One thing, however, is for certain: the masses have made their voices heard and will continue to demand actual governmental intervention. The simplest form of intervention is to set up or expand social programs of various kinds, along with extended public assistance and related projects. All of these require government funding, and the only way that a major oil-producing nation can generate such funding is by producing more oil.

The key to the balance of power is that in past years, the necessity to maintain an oil-price monopoly trumped concerns about social unrest. This equation has now become inverted. Going forward, maintaining social order will be more important than ensuring the highest living standards for the ruling elite. In order to maintain their hold on power, they will have to make some concessions, and they must pay for those concessions from increased crude oil production.

This article ("Saudi's 36 Billion-Dollar Bid to Beat Unrest") from Thursday's Financial Times shows that the Saudi royal family plans to spend 36 billion dollars on new social programs in the immediate future.

This recent Wall Street Journal article ("Iraqi Lawmakers Switch Funds to Social Programs") demonstrates that Iraq also is eager to quickly spend money on new social programs:

Even in Kyrgyzstan, which is not directly in the Middle East but which is an important oil producer, the government has pledged to give teachers and medical personnel a significant pay hike as a way of preemptively preventing social discord (see Kyrgyzstan Unrest; Pay Hikes Promised).

Any guesses as to where Saudi Arabia is going to get thirty-six billion dollars, or where Iraq will find similar billions, or where the money will come from to fund significant pay hikes in Kyrgyzstan? One way or another, they're going to have to massively produce more oil, since they have no alternative source of revenue which can be increased by a sufficient margin. Multiply this by a few dozen countries and multiply that again by a large factor for future social programs. It's only a matter of time before the market realizes this and we experience a dramatic decline in the price of crude.

Therefore, over a period of one or two years, we are likely to see a huge increase in oil production in those countries which are either directly threatened by political unrest, or who believe they may be threatened and choose to act preemptively to prevent discord. As the OPEC cartel crumbles under this new world order, the price of crude oil will plummet. There is constant chatter in the media about when regular unleaded gasoline will once again exceed four dollars per gallon, as it had done in the late spring and early summer of 2008. The exact opposite will occur: the price of gasoline in many parts of the United States will sell for less than two dollars per gallon, as it did near the end of 2008 and for the first several months of 2009.

The more popular and overcrowded is any trade in the financial markets, the more certain that it will fail. With everyone currently talking about how much higher crude oil prices will go, and how much recent events in the Middle East will add to the "risk premium", we are virtually certain to see the exact opposite scenario. The greatest certainty over high oil prices occurred in July 2008 when the only debate was about when crude oil would reach 200 dollars per barrel. The possibility that it could move lower wasn't even seriously considered by most observers; the end result was a plunge of more than 75% in less than a half year.

We are not likely to see such a dramatic plunge in the next year, since we didn't get as high in the first place. However, it is quite possible for crude oil to lose half of its value by 2012, thereby putting it close to 50 dollars per barrel. Especially with everyone looking up, a downside bet is almost certain to be highly profitable. It is like betting on a horse race in which the favorite has the longest odds.

The respected Market Vane survey, which has been in existence since 1964, recently showed 97% of traders who were bullish on crude oil. This level of extreme nearly always coincides with a historic price peak. Sentiment toward related products such as heating oil is also at 97%. The only commodity which is even close is silver, which has 96% of traders indicating a bullish bias. In recent days, many mainstream media outlets have begun their financial segments by mentioning the price of crude oil first, and the Dow Jones Industrial Average second. This inversion of the normal order has not happened since the early summer of 2008 when the oil price was on the verge of its collapse of more than 75%.

Of course there are other important factors outside of Middle East government policy. During the past several months, we have seen nearly vertical increases for many commodities, while the shares of most commodity producers have been less energetic and have experienced notable insider selling. The implied volatilities for listed options fell to their lowest levels since the summer of 2007, as measured by VIX. This indicates that there is almost no fear of a double-dip recession among today's investors.

Many emerging markets have been in notable downtrends since early November 2010. With about three fourths of the world's population living with housing bubbles, which have become truly extreme in part or all of dozens of countries including China, India, Brazil, Canada, and Australia, a collapse in housing prices is likely to lead to an unexpected drop in consumption of all nonessential goods. Commodities worldwide will suffer from unexpected GDP contractions in countries with slumping real-estate prices.

Another key feature of the financial markets is the delay between the decision to produce commodities like crude oil, and the actual execution of those plans. It takes several years for most commodity producers to go from initial production plans to full-scale output. Since the prices of many commodities did not begin to rise sharply until about five years ago, it is only now that many long-planned projects around the world are finally going full tilt. This will lead to a surge in output at the same time that there is political pressure to increase production further.

Even U.S. crude production, which most analysts had assumed would be in a "perpetual downtrend", is likely to increase substantially due to a combination of recent huge discoveries and the technology to exploit them (see New Drilling Method Opens Vast U.S. Oil Fields).

While no one knows for certain, it is also likely that many autocratic governments in the Middle East and elsewhere had been quietly stockpiling crude oil for potential use "as needed". The more urgently that threatened politicians need to placate their citizens, the more likely that oil will just as quietly be sold from these stockpiles so that governments can loudly declare that they are "listening and responding to the will of the people", and thereby enact new food assistance programs or higher wages for workers or low-cost housing or expanded pensions. Everything costs money, and there is only one logical, reliable source of that money in those places where the political risks are highest and the supply of crude oil is greatest.

One interesting question is the best way to profit from an anticipated decline in the price of crude oil. The most obvious way is to sell short a fund of futures such as USO, which because of its structure will lose roughly 2% monthly as time passes even if the spot price of crude oil remains unchanged. There are numerous funds of oil producers which have surged sharply since the summer of 2010, including XLE and OIH, which also make ideal short positions.

Technically, all three of these are not only fundamentally overvalued, but incredibly overbought technically regardless of which quantitative measures you prefer to use. All of these are highly liquid, with tiny bid-ask spreads, so you can trade millions of dollars without having even a slight impact on the price.

A viable alternative is to short SLV, a fund of silver futures, since the price of silver has increased even more than the price of crude oil since last summer, and will therefore almost surely fall by more than 50% and probably more than 60% from its recent 31-year high, whereas crude oil may end up dropping by "only" about half from its February 24, 2011 peak of 103.41 U.S. dollars per barrel.

It is possible that the current overhyped hysteria over higher oil prices will prove to be the correct outcome, but nearly all of the facts argue otherwise. As Damon Runyon wisely said a century ago, the race is not always to the swift, nor the battle to the strong, but that's the way to bet.

Disclosure: I am long TLT. I am also short EWY, QQQQ, and SLV. I have no positions in oil or oil shares, directly or indirectly.