The Saudi Bluff: A Sign Oil Prices Are Likely To Rise Dramatically And A Trade For When They Do

Includes: BNO, USO
by: The Independent Investor

I love these stories. They always make the headlines, and almost always are equally likely to get knee jerk reaction. That was exactly the case with the recent "promise" by Saudi Arabia to raise output and do what it takes to lower energy prices. I also think the recent pullback in commodity prices in the creates a great opportunity to get long Brent ETF (NYSEARCA:BNO) and WTI ETF (NYSEARCA:USO) at today's level in the options market.

Not only does Saudi Arabia not have the right kind of crude that most of the European countries who get the majority of their oil from this middle eastern country need, their reserves are totally unverified as well. Indeed, many experts in the West think Saudi Arabia has grossly exaggerated their oil reserves, and their capacity to bring them to market.

Contrary to popular belief, Saudi Arabia is not the oil kingdom it used to be. With a rising budget that require a break-even price of oil in the Brent Market of around 100 dollars a barrel just to cover their country's social needs over the coming years, the Saudis also face a 20-25 dollar a barrel refining cost to turn their almost exclusively heavy crude to the kind of sweet crude that is most used by the countries they export too.

Compare this with Libya, whose oil is almost exclusively sweet crude, and whose cost of extraction is around 2 dollars a barrel, and you begin to see the problem with putting too much faith in this Saudi promise.

What is funniest to me is this is the same empty promise made by Saudi Arabia that they made during the Libyan crisis, a time when oil prices skyrocketed even after the Saudi claim to once again significantly raise production.

So, why make the promise at all? While, again, call me cynical, but we are going to the months of peak demand for oil during an election season. OPEC is largely divided into two camps, the anti-west camp led by Iran that includes Venezuela and Algeria, and the pro-Western Camp that includes Saudi Arabia and Kuwait.

The Saudis are also very fearful of Iran getting a nuclear weapon, and are the only country that has publicly given Israel flyover rights to potentially launch an airstrike on Iran's nuclear reactors.

What does all this mean. It means the Saudi government is the only large oil producing national over whom the U.S. has any leverage. Since the Saudi still invest mostly in the U.S. economy and they U.S. support in sanctioning and continuing the effort to prevent Iran from developing a nuclear weapon, they are making a promise they likely can't keep. We are also entering the summer season when oil prices are usually near their highest levels for the year.

Oil Trends

Saudi Arabia has never had their reserves verified, has firmly resisted any independent audit, and simply lacks the right kind of oil. The fact that Saudi Arabia, not Libya Iraq, both likely countries with larger and more sought after reserves of sweet crude, were not the countries who promised to raise output, tells us that OPEC's spare capacity is very limited. Look at the following chart.

(Click to enlarge)

As we can see, since 2004 OPEC's production numbers have not moved up even as oil prices have moved higher.

Saudi Arabia's share of OPEC's excess capacity has been dropping as well.

(Click to enlarge)

As prices have risen capacity and output numbers have flatlined to declined. Contrast this with Exxon's prediction in their budget that energy demand will rise by nearly 30% over the next 15 years.

Today the U.S. economy has stabilized is now growing at a comfortable 2.5-3%. The S&P 500 (NYSEARCA:SPY) is also up over 30% this year, and even WTI price have rebounded from the mid-seventies to around 110 dollars a barrel today. With Asia still weak and the dollar at the higher end of its five year range, it is likely that an acceleration of global growth at the time of peak demand in the summer could cause an oil spike at the worst time for Obama.

With Syria is still in chaos and the prospect of an Israeli strike on Iran is high as well, oil prices are likely to climb as growth around the world accelerates into the back half of the year. While tech stocks like Apple (NASDAQ:AAPL) and financial stocks like JP Morgan (NYSE:JPM) have been the best performers in the market so far, oil stocks could very well breakout as prices rise in the summer months With the fed unable to act other OPEC countries unwilling or unable to take any significant steps to raise output, the Saudi promise is the best we can get.

Their are many ways to play the oil market, but with commodities pulling back on Fed speak and the Saudi's likely unfulfillable claim, sometimes the best trade is also the most straight forward.

Getting long the WTI and Brent ETFs with in the money calls during the summer months rather than trying to play some of the oil producers who are still significantly tied to natural gas production is likely the best trade here. With volatility levels low and prices having pulled back nicely this trade sets up a nice risk-reward ratio.

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