Crude Oil: A Casualty Of War

by: Andrew Hecht


Escalating tensions.

Well-defined but complicated sides.

Oil makes new multi-year lows.

The divergence with stocks in 2015 means a bear market in U.S. equities in 2016.

All signs point lower for crude except one.

2016 OIL2016 has started with quite a bang in markets. Global stock markets are plunging, crude oil traded to the new lows and volatility is picking up all over the place. 2015 was a year of volatility, a year where a trader rather than investor mentality was appropriate. This is always the case in volatile markets. As we move forward into 2016, it is starting to look like the action last year was tame. Considering the wild market action during the first week of the New Year, it may be a case of we ain't seen nothing yet!

Crude oil had a miserable 2015 for producers. The price dropped by around 30.5% on NYMEX crude and Brent crude oil plummeted by almost 35%. Over the first week of 2016, it has been more of the same in the oil patch, however, given world events, it makes a falling oil price counter intuitive.

Escalating tensions

It became clear in 2015 that the relationship between Iran and Saudi Arabia, two of the most influential members of OPEC, was deteriorating. Each nation lined up against each other in Yemen, a nation with a long border with Saudi Arabia. A revolution in Yemen created a war between Shiite- and Sunni-backed forces. Each side supported by Iran and Saudi Arabia respectively. The conflict, a proxy war between the two oil-producing giants, complicated the situation in the Middle East from a global perspective.

The Saudis are a long-standing ally of the U.S. and West. However, the nuclear non-proliferation deal with Iran left Saudi Arabia wondering how committed their traditional allies actually are. Under the deal with Iran, sanctions will ease and Iran would be able to access $150 billion in frozen assets. This comes at a great time for the Iranian government given lower oil prices; it also comes at a terrible time for their enemy, the Saudis. Lower oil prices have caused economic hardship in the Kingdom of Saudi Arabia. Falling petroleum prices has caused the House of Saud to borrow money for the first time since 2007 through the international debt market. It has also caused the government to cut back on various domestic social welfare programs and raise prices on energy and utilities in the nation. Last week, the Saudi deputy crown prince said in an interview in The Economist that the nation is considering an initial public offering to privatize Aramco. Aramco accounts for 100% of Saudi oil production and would be the largest publicly traded oil company in the world by more than two-fold. If Aramco were to go public, it would rival Apple as the world's biggest listed company but at the same time, the listing would amount to a panic move. The Saudi Royal family would be selling a part of their crown jewel to raise money. The move amounts to financial panic. Does it make sense to sell at a price that is less than one-third the value less than two years ago? The proxy war with Iran has increased military spending at a time when oil revenues are plunging. Therefore, in 2015 oil prices and geopolitical events strengthened Iran and weakened Saudi Arabia.

Over the first weekend of 2016, the Saudis decided to carry out a death sentence on a Shiite cleric who was actively speaking out against the government. A harsh response from the Iranian government met the execution. Iranians burned the Saudi embassy in a move reminiscent of the late 1970s. The Saudis responded by severing diplomatic ties with Iran and booting their diplomats out of the country. The war of words escalated, the proxy war in Yemen became more violent. Under ordinary circumstances, increasing tension and saber rattling in the area of the world that contains more than half the world's oil reserves would cause a shock to the price of the energy commodity. This did not happen; the price of oil weakened.

Well-defined but complicated sides

The escalation of tension in the Middle East takes on a new dimension when you consider that the Saudi Arabia and Iran are both OPEC members and two of the top 10 oil-producing nations in the world. The Iranians have a cozy relationship with Russia these days given common interests in Syria. Russia is one of the top three producers of oil in the world. Meanwhile, Kuwait, Qatar, the UAE and Bahrain all pledge allegiance to the Saudis. Other than Bahrain, these nations are all OPEC members and major oil producers. No one knows where war-torn Iraq, the eighth-largest producer of oil in the world, stands in the conflict as the government and power shifts in the nation on a daily basis but given their geographical proximity to Iran, Iraq is more likely fall under the Iranian sphere of influence.

In terms of 2014 total annual daily oil production, this means that there is around 20 million barrels per day on the Saudi side of the equation and 17.6 million on the Iranian side. The swing production in the battle is the United States, currently producing over 9 million barrels per day and Oman with just under one million. Oman has traditionally acted as a mediator in the region. To complicate matters, the U.S. relations with Iran have strengthened given semi-common goals with respect to Syria and the war against terrorism in Iraq and other areas of the Middle East. Those common goals have weakened U.S. ties with the Saudis. This leaves the United States somewhere in the middle of the escalating conflict in the region.

The sides balance one another in terms of oil production, but it also guarantees one thing: no policy changes in OPEC as member nations in the Middle East are on opposite sides of the conflict and have cut diplomatic ties with each other during the first week of 2015.

Oil makes new multi-year lows

The December 4 meeting of OPEC resulted in nothing of substance in terms of the cartel's policy toward production cuts. In fact, the meeting yielded the opposite. The attitude of the membership was a case of the Russians and Americans have no production ceiling, why should we adhere to one? The Iranians stated that it was their "sovereign right" to increase oil sales, which will add up to another million barrels of petroleum a day to global output. Meanwhile, the price of oil continues to fall. On Thursday, January 7, the price of NYMEX crude oil fell to $32.10 per barrel. Click to enlargeCrude fell below key support at the December 2008 lows of $32.48 and traded down to the lowest level since December 2003. Last Friday, it settled at $33.16 per barrel on the February NYMEX contract. Brent crude oil traded to lows of $32.18 the lowest level in almost 20 years last week and closed at under $33.50 per barrel on Friday.

One would intuitively think that all of this mess in the Middle East should be very bullish for the price of crude oil. After all, spreading violence in the region threatens key production and refining capacity. The current military operations in Yemen alone threaten to spill over to
Saudi Arabia now that the relationship with Iran has deteriorated as they share a long and important border. It also threatens key logistical shipping lanes like the Persian Gulf, the Straits of Hormuz and the Gulf of Aden. The casualty of the escalation of tension, war and rhetoric in the Middle East with sides lining up against each other is crude oil. The price has fallen to a level not seen in more than a decade and this favors the Iranians who are accustomed to economic hardship and will receive a huge injection of funds by virtue of the 2015 agreement. The Iranians know that lower oil will harm the Saudi economy and therefore they will continue to sell using crude oil itself as a weapon in the war. Meanwhile, lower crude has dire consequences for U.S. equity markets.

The divergence with stocks in 2015 means a bear market in U.S. equities in 2016

While crude oil is trading at 2003 prices, the Energy Select SPDR (NYSEARCA:XLE) remains above the October 2011 lows. While we have seen weakness in the stock market over the first week of 2016, it has been a response to the events occurring in the Chinese domestic stock market to a greater degree than to the falling price of crude oil.

Alarm bells are going off all over the place during the first week of 2016. Many analysts from major banks have tempered their usually bullish equity projections for the year. George Soros came out during the week with a prediction that the current selling in the stock market could be the tip of the iceberg. Soros said that, "China has a major adjustment problem... I would say it amounts to a crisis. When I look at the financial markets, there is a serious challenge that reminds me of the crisis we had in 2008." Whatever you think of Soros' politics, the investor has an incredible record of accomplishment on calling and profiting from huge market moves.

The divergence between the XLE and the price of crude oil could be the cause for the next leg down in stock prices in the U.S. The bottom line is that there are so many companies in major U.S. indices in oil or oil related businesses. These stocks have not yet reflected the absolute slaughter of the price of the energy commodity since June 2014. The price of NYMEX crude oil has dropped from $107.73 to lows of $32.10 this past week. The over 70% decline in oil prices has not yet caught up with the XLE or the stock market. In 2003, the XLE was under $25 per share. Last Friday, the XLE was trading at more than double that level at $55.99 per share. Click to enlarge This is a huge divergence and could be an ominous sign for the equity market in the United States and around the world. At the very least, unless there is a miracle in the world of crude oil and the price recovers quickly and substantially, we are in for a bear market in stocks in 2016.

All signs point lower for crude except one...

Even though the price of crude is making new lows and has taken out the December 2008 lows, it still might not be cheap enough. Market structure in crude oil is telling us that the price is heading lower. Term structure, or the forward curve in crude oil, is trading at around the 25% level on one-year NYMEX crude oil spreads with Brent one year spreads trading around the same level. The wide level of contango is a bearish signal. Brent crude oil is trading at the smallest premium to WTI in years, which is a sign that there is little or no political premium on crude oil and that the world is awash in the energy commodity, another bearish signal for crude oil. Refining or processing spreads have displayed divergence -- gasoline crack spreads are strong for this time of the year, but heating oil crack spreads are at the lowest level in years. This may just be the result of low inventories of gasoline at a time of the year where seasonal demand is historically low. However, the beginning of this winter has been more than mild across the U.S. perhaps encouraging drivers to use the opportunity of the lowest gasoline prices in years to increase miles driven. I view the current state of refining spreads as neutral to bearish for the price of raw crude oil. Increasing Iranian production, the never-ending flow of crude oil from Russia, U.S. production above the 9 million barrel per day level and OPEC members selling as much as they can produce each day is the current state of affairs in the world of petroleum. Therefore, all signs point to an even lower price for the energy commodity, all that is, except for one.

While the price of oil has been an initial casualty of the escalation of turbulence in the region, the potential for production problems will increase as the situation becomes more dangerous. Any violence or military operations from either side of the conflict (and let us not forget the terrorist angle) that affect oil production or refining in the region will have an immediate and violent effect on the price of oil. We may just wake up one morning and find the price of oil double the price that it was trading at the day before as we did in August of 1990 when Iraq invaded Kuwait.

Events in the Middle East have been bearish, thus far, for the price of crude oil and the energy commodity is likely to put in even lower lows. However, be careful, this market is not a no-brainer on the short side. The chances for extreme volatility in the oil patch in 2016 have risen with the temperature in the region. Meanwhile, one of the best bets out there could be the divergence between the XLE and equity markets in general and the price of crude oil. The equity markets continue to look at the price of crude with rose-colored glasses. Once the situation comes clearly into focus, it is likely that stock prices will move significantly lower and the first week of 2016 will go down as a presage to a year of extreme ugliness in equities.

As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on energy and equity markets to illustrate the real value implications and opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.