As I mentioned last week in my article recommending airline stocks, oil is presently overvalued. Putting aside my long-term bias toward believing in peak oil, I must admit that in the short-run, nearly all signs point to crude going down. A fairly rapid fall to $80/barrel or further is quite likely.
Here are seven reasons why.
1. Crude inventories are up
Generally, to get a economic shock, you need a shortage. As the below graph of U.S. oil inventory shows, we would have to face profound sustained cuts in supply to dip toward shortage. In 2008, when $147/barrel oil occurred, inventory was quite low and well below the normal range. Today is the opposite with stockpiles up and at the high end of the normal range. Stockpiles of finished goods including gasoline, kerosene, and distilliate fuel oil are also up versus this time last year.
click to enlarge images
2. The global economic recovery is slowing
Last year we witnessed a sharp rise in crude consumption worldwide as economies continued their strong recovery from the 2008 recession. This year's rise in demand should be much more tame as developed economies have stagnated with Western Europe and Great Britain appearing to be on the verge of returning to recession while other developed nations such as the United States witness only sluggishly moderate growth. Some developing countries such as Brazil appear to be seeing the rate of economic growth fall significantly this year. And as the Wall Street Journal noted, the two-speed economic recovery between the developing and developed world is threatening to unleash great inflation and destabilize the fragile recovery. Also, impending substantial government budget cuts in many large economies may further retard economic growth. Unless China can single-handedly power the world economy, oil demand growth should slow this year and next.
3. Geopolitical pressures should blow over
While things are really tense in the Middle East presently, it's important to note that historically, the vast majority of Middle Eastern flare-ups dissapate quickly. Unless the present unrest spreads to Kuwait, Saudi Arabia, or Iran, it is hard to see any supply shortage arising out of the present disturbances. The excess OPEC oil supply is several multiples of oil production in any of the currently unsettled oil-producing states. In addition, none of the impacted oil supply is near to the United States, which has helped keep NYMEX crude at prices well under the UK's Brent crude price.
4. Geopolitics cannot drive the oil price in the long run
The huge spike in oil in 2008 was caused by a combination of a historically weak US dollar and a tighter crude market with lower inventories (see point #1). It was not caused by conflict in the Middle East. Wars such as the Iran-Iraq War of the 1980s, the Persian Gulf war of 1990, or the recent American military adventures in Afghanistan and Iraq have failed to cause durable changes to oil's price. While bloodshed can lead to short-term oil spikes, the long-term value of oil is driven by a combination of supply & demand and the relative value of the U.S. dollar versus other currencies rather than bombings or riots in the Middle East.
5. Oil is historically overvalued compared with natural gas
Oil traditionally trades at a ratio of roughly 8-12x the price of natural gas. In the past year, it has blown out to an unprecedented 25x the price of natural gas. The ratio sits at 24 today. Oil and natural gas are substituable fuels to a significant degree, and companies such as Clean Energy Fuels (NASDAQ:CLNE) and Westport Innovations (NASDAQ:WPRT) are working diligently to make natural gas a realistic alternative to petroleum for vehicles. It's hard to imagine, with each unit of energy available from natural gas so much cheaper than from petroleum that this ratio will remain at historic levels. To be fair, this point can also be used to argue that natural gas should spike, though natural gas also faces a glut of inventory.
Here's a historical chart of the oil/natural gas ratio.
6. The U.S. dollar is stronger than in 2008
The 2008 oil spike occurred during an unprecedented period of dollar weakness with the euro fetching $1.60 and the British pound worth more than $2.00. Today, both currencies are trading far from those levels and the dollar index has a much stronger technical base under it. Since oil is priced internationally in U.S. dollars, a stronger U.S. dollar should put a lid on higher oil prices. Here's a long-term US dollar chart. Note the rising trendline that the dollar is now sitting on. If the dollar bounces off this trendline, it should be a catalyst for falling oil.
7. Oil faces significant resistance
Finally, NYMEX oil finds itself smack up against strong resistance that should kill the rally. The $100 price level is significant resistance by itself due to being a key psycological level. Add to that the significant chart resistance at $100 created during the last surge, and this level should be tough to crack. The market tried to take out this level on Thursday as the NYMEX crude contract traded up to $103 but reversed and closed at $97, invalidating the breakout.
Here's a long-term chart showing the resistance levels:
Crude oil is highly vulnerable to a massive breakdown as soon as the Middle Eastern tensions cool or weak economic data arrives. One way to set the trade up would be to short now and set a tight stop just over $100. There's a decent chance this will fail, however, as Thursday showed, it is easy to run stops on low volume. The positional oil short play is to enter a short position here, set a stop just over $110, and target a big move south. $92/barrel offers weak support, $80/barrel offers fairly strong support, and $65 should be the max downside for oil in the foreseeable future. The odds are quite nice on the short side of crude here.
Disclosure: I am long UNG.