Oil: Slippery Road Ahead

On Wednesday, a Goldman Sachs analyst came out again to say that oil is headed for $149 by the year-end. Looks like Goldman has made big bets on rising oil prices, and of course, this analyst may just trying to turn that position into profit.

But I wonder if this analyst really knows how the fundamentals of analytics work. Goldman is again harping on the supply-demand equation, while we have seen clear indications that demand for oil is highly elastic. People will cut back their oil consumption (the biggest consumer, of course, is the US, where individual consumers are the primary oil consumers) if oil prices try to rise further.

Most financial models are highly unrelated to real life, and most of them fail in real life situations. If that is not the case, computer programmers and analysts would be the richest people in this world. So in the model world, demand of oil will remain static or will keep rising; but in the real world, just the opposite is true. Especially since higher oil prices will help in finding alternative energy sources.

Now this almost sounds cliche' and most people don't want to believe that we are close to any breakthrough there, but we already have at least 10 car models lined up for release before 2010 which have gas mileage of more than 50mpg. Assuming current average mileage for vehicles is 20mpg, this mileage efficiency equates to almost a 50% reduction in consumer demand of oil in 2010 and beyond. But investors will see the oil prices going down much before, as the real demand tapers off.

This week's US oil inventory data including the follow stats: US crude oil stockpiles rose almost 9.4 million barrels while gasoline inventories declined by almost 6.2 million barrels. What do these figures tell me? One, crude oil demand declined significantly this week. This implies refiners have enough crude already for the demand that they anticipate in the coming weeks. Second, gasoline stockpiles declined because consumer who saw gas prices decline by almost 50 cents within two weeks filled their tanks for a "just-in-case" scenario. Does that mean "real" demand for gasoline went up so much this week? Absolutely not. I once again emphasize the word: "real".

But unfortunately, Goldman's demand-supply models don't differentiate in real and artificial demand. Or simply put, models do not have intelligence. They simply rely on data, and data can be very skewed for multiple reasons. My sympathies are with Goldman if they are long oil.

For the investors, my advice is to avoid trading in oil. But if you absolutely have to, then short every uptick in oil prices. In my opinion, at current levels any price of oil to the north of $120 is a good shorting opportunity. Oil will be trading below $90 in next six months. Investors who have bought ETFs like United States Oil Fund LP (USO) should book their profits and close their open positions. Unfortunately, people who bought USO when oil hit $147/bbl will have to close their positions at a loss. But it's better to minimize the loss by closing the positions now.

Another factor that will contribute to oil's fall is the rising dollar. No matter how skeptical we grow of the US economy, the tight correlation between the US economy and rest of the world's economies means that the US dollar will be gaining further; if the situation gets bad here, then it will be worse in the rest of the world. We can see this tight correlation religiously reflected in the stock markets of the world. If the Dow and S&P go down, the next day sees Asia to Europe decline. If the stock market here goes up, the next day other stock markets rise, too. The dollar has still more room to rise further. And that will take the road for oil even more slippery.

For the Oil Service HOLDRs ETF (OIH), fundamentals remain strong, but again, it's highly correlated to oil prices, so it might be going down with it. However, I would suggest buying OIH if it goes down below $165 (its support area). But once again, buying OIH does not mean you should buy oil or USO. USO in particular is headed towards $80 from its current level of $93.

For traders, the volatility in oil prices will still be very high and they will have a good opportunity to utilize it to their advantage, as long as they keep in mind that the graph for oil is heading downward, barring a 1-2 day price rise here and there.

Disclosure: I don't have any positions in USO, OIH. And I am neither long nor short oil, if you excuse 15 gallons in my car as not being long oil/gasoline. But I plan to short USO if it goes above $96 mark.

Comments

[mangolfer:]

Good article. I owned DUG and just got called out on my "trailing stop". I plan on buying into it again. In addition, I'll may be buying DTO and DOY.

2008 Aug 21 07:40 AM

[Tim Miles:]

Your article treats the United States in isolation. The reality is that rising demand for petroleum in China and other emerging nations will keep oil prices high in the near future. A recent NY Times article shows what a bind U.S. oil companies are in too. And drilling for more domestic oil is not going to improve anything either.

2008 Aug 21 08:07 AM

[coaster:]

Since USO is now above $97 I assume you are short and I suspect it will be a short term position.

2008 Aug 21 01:33 PM

[G. L. Turner:]

Well, Tim, you say that the article treats the US as being in isolation. Yet, the traders seem to treat the US INVENTORIES as if they represent the Entire Global INVENTORY and Demand status. So, we can't say that Chinese demand can rock the global energy market as much as we discount the US drama. Why do we go nuts with each US inventory report as if it was the main determinant of price globally, especially when they are opposing trends and statistics??....THAT IS, unless you are the golden boys of WS and ABSOLUTELY NEED to get your Nov. long positions covered along with those swaps you guaranteed to give the pension funds you induced into going ridiculous long in the Com. Index Funds....you betcha you are scrambling to make good on 'getting that price of oil up" to $147 by November.

When the traders and funds realize that anything over $90, even in the midst of geo-tensions and a mystery tropical storm that is dead on the Atlantic side of Fla. but still lives vividly in the minds of traders as if it had already hit LA. after crossing land 3 times, we might see sanity return and the debate about s/d fundas being out of sync as being untrue.

I am so amazed at the blatant naivety of most of these players....and how they are now, once again trying to pull the IVs out of the goose that we finally rushed to the hospital in July...thought there was some hope...Hmm, maybe not!
Y

2008 Aug 22 01:28 AM

[Dan S1:]

Gold Digger, good article. I agree with your commentary. This current upside move in energies is a retracement of a main downtrend. Expect to see lower prices going into end of year 2008.

However, this long term commodity bull market is not over and I expect record highs on all energies in 2010 or 2011.

2008 Aug 22 12:20 PM

[User 223703:]

Major incorrect assumption is that adding 10 models with 50mpg will have any effect on the enormous population of existing autos on the road. Only reduction in miles driven will have any effect for the next 5 + years.

2008 Aug 22 12:29 PM

[Kunst:]

"rising demand for petroleum in China and other emerging nations will keep oil prices high in the near future."

Don't you understand that the US is a lot more able to absorb high oil prices than countries with far lower per capita disposable income? Why is it everyone thinks that poor America (the country that "manufactures" the currency of oil) is going to cut back while much poorer countries are going to keep on increasing consumption? You are confusing population with wealth.

2008 Aug 22 10:40 PM

[Kunst:]

Seeking Alpha: what's with this &quo...? Are you trying to match Marketwatch's ampersand debacle?

2008 Aug 22 10:41 PM