Gulf Arab Countries Shorted Oil In 2015 - How Low Can Prices Go?

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Includes: OIL, USO
by: Dorien Xia

Summary

Gulf Arab OPEC countries have shorted oil in 2015.

U.S. total petroleum product inventories are starting to stabilize.

Current prices are not far above the inflation adjusted price in 1999 when OPEC and non-OPEC worked together to cut production.

On the bearish side, Gulf Opec shorting combined with hedge fund shorting could test the oil lows set in 1999 when OPEC and non-OPEC worked together to cut production.

On the bullish side, stabilizing U.S. inventories could imply that oil markets are more balanced than current prices suggest.

Background

The past 2 years have been a blood bath for oil prices. The decent started last September, when overproduction from the United States caused prices to dip to the 70 dollar per barrel. The price later went down even further as Saudi Arabia and OPEC decided to not cut production in November 2014. Having halved in value from a year ago, prices were in the 40-60$ range from January to December 2015 before plunging further when Saudi Arabia as well as OPEC announced that they would raise the output ceiling instead of cutting production in Dec 2015. Adjusting for inflation, oil prices are at historic lows not seen since the 1990s.

While most everyone agrees that oil prices should rise above current levels, the timing of this rise is uncertain. Goldman Sachs claims that oil will not rise above 50 dollars until 2020, while others claim that the next oil rise could be right around the corner. Taking a look at the many factors within the oil patch, we can analyze the factors effecting oil prices and whether prices should rise fall or stay the same throughout 2016. Although there are many factors influencing global oil prices, the main ones that I will focus on today include: Gulf Arabs Shorting Oil, Historical Oil prices, and U.S. Inventory changes.

Gulf Arabs Shorting Oil

For those unfamiliar with modern day oil trading, oil prices are no longer directly determined by physical transaction of wet barrels of oil. Instead, prices are set by the transfer of paper contracts for oil delivery. Most people who sell paper contracts intend to deliver the product. However nowadays, large hedge funds and international institutions have the ability to sell paper contracts when prices are high before buying them back (preferably at a lower price than you sold for). The act of selling paper contracts before buying them back is called Shorting Oil. The net effect of oil shorting on is to temporarily bring prices down before the contracts are bought back and prices return to equilibrium. Small amounts of oil shorting would have a negligible impact on prices. However, the initiation of large short positions by Hedge fund or Foreign entities would have the safe temporary effect on prices as a flood of physical wet oil barrels coming to market.

In July 2015, it was revealed that at least 2 sovereign wealth funds, within OPEC, were shorting oil. The article was from July 2015, and claimed that OPEC countries were shorting oil when prices were 50-60$/barrel. Although nobody knows which countries within OPEC or how long those countries have been shorting oil, we do know that Saudi Arabia and the gulf Arabs were the only ones who resisted a production cut at the most recent OPEC meetings. Furthermore the location of the paper trail in Dubai makes it likely that short oil positions originated in the Arabian Peninsula.

Significance of Oil Shorting

Due to the secrative nature of soverign wealth funds in the Arabian Peninsula, it is impossible to determine for certain who is shorting what or why they are doing it. However, since Gulf Arabs produce a sizable amount of oil, it is unlikely that oil shorting was done purely as a money making method. Shorting oil would reduce the value of their product which would result in less money. More likely, Saudi Arabia and the Gulf Arabs were shorting oil to use it as a geopolitical weapon. Possible reasons for this behavior include but are not limited to: bankrupting U.S. frackers, putting the screws on regional rivals Russia/Iran, and forcing prices down far enough to bring Non-Opec to negotiate a production cut.

How low can it go?

As can be seen in the chart below, the historical price of oil has varied greatly over the past 40 years. While many people reference the most recent oil crash of (1999) which brought oil prices down to 9 dollars a barrel, that analogy is not fair since, 9 dollars in 1999 was worth a lot more than 9 dollars today. Adjusting for consumer price inflation, oil prices over the past 40 years can be seen in the chart below.

Source: Wall Street Journal

At today's price of 33$/barrel it can be seen that we are not too far from the 40 year low of 20 dollars a barrel set in 1999. Back then, the price of 20 dollars a barrel was what it took to bring Non-Opec countries to the bargaining table. Taking into account the fact that oil today is harder to extract than it was in 1999, it is possible that a similar deal happens today at prices higher than 20 dollars a barrel.

Bull Case -U.S. Storage 2015 stabilizing compared to 2014.

From Dec 2014 to August 2015, we have seen both weekly declines in crude oil inventory, and weekly declines in refined product inventory. However, never have we seen declines in both crude and refined product inventory within the magnitude required to bring total petroleum stocks down. The crude oil draws in 2015 were mostly caused by refineries, not supply demand equilibrium. The EIA's total petroleum stocks data avoids the bias towards crude inventory by counting the entire inventory of petroleum products within the U.S. (crude, propane, gas, diesel, jet fuel, heating oil etc).

While the total petroleum stocks increased every week throughout 2015, over the past few months something has happened to total U.S. petroleum stocks that has not happened in a long time…. Stocks drawing down. Comparing data from Nov-Dec 2015 to data from Nov-Dec 2014, we can see a sizable difference in total petroleum product builds/draws.

Click to enlarge

Click to enlarge

Total Petro Stock Change by Year

Year

2015

2014

2 months

10.1

16.7

1 month

3.4

27.7

Click to enlarge

Sources: EIA

As can be seen by the charts/tables above, crude stocks are finally starting to level out. While inventories are still building at a rate of approximately 3.4 million barrels per month, this is much slower than the 27.7 million barrel/month inventory build from Dec 2014.

Furthermore, since the united states still has ~185 million barrels of available crude oil storage and ~184 million barrels of gasoline storage, it is unlikely that stabilizing inventories are a result of lack of storage. Instead stabilizing inventories are a sign of production declines from the United States and a more balanced oil market.

Conclusions

OPEC surprised markets again on Dec 4th when they decided to raise the production ceiling by 1.5 million barrel/day. On the bull side, stabilizing U.S. inventories combined with geopolitical risk could bring oil prices to increase. However on the bearish side, the current shorting practices in addition to bearish sentiments from Investment banks such as Goldman Sach's, and Iran's re-entry could push prices lower. Although nobody knows what will happen in 2016, my personal opinion is that Investment Banks + OPEC will continue to short oil until we see cuts from outside of OPEC. If successful, this move will solve the fundamental supply situation and push prices higher in the long run. However nothing in the oil market is guaranteed and I would not be surprised if we had another volatile year in 2016. For those willing to wait 1-2 years, now may be a good time to start accumulating oil stocks. Happy Trading!

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.