Why We're Short Oil

Includes: OIL, USO, XOM
by: Jason Kelly

My recent decision to short oil sparked controversy. I have maintained an interest in bargain-priced oil companies for years, so to short the price of the commodity appears to some to be a contradiction. It's not. Oil majors are proven good investments through various oil-price environments.

Oil averaged $20 per barrel in the 1990s, but started climbing in the recovery following the dot-com crash, then shot to more than $130 ahead of the subprime mortgage crash. It then collapsed all the way down to less than $40, but bounced immediately. It has traded mostly in an $80-$100 range for a year now, but shot above it to $103 last week and to $106 earlier this week before settling back to $105 yesterday.

If the performance of oil-major stocks tracked the price of the commodity, we would expect to see the price of Exxon Mobil (NYSE:XOM), for instance, to have gone nowhere in the 1990s, climb from the dot-com crash to the subprime mortgage crash, sell off in oil's collapse to $40, then spike with oil's recovery. Instead, XOM rose from a split-adjusted $12 in January 1990 to $39 in January 2000. The shares topped $90 in the oil spike ahead of subprime, so tracking was evident in that case, as it was in the correction that followed, when XOM fell to less than $60 before staging a full recovery to its current $93 area. There was a lot more going on in the wake of subprime, however, and all stocks as a block fell dramatically. For the most part, oil-related stocks can perform well in a variety of oil-price environments, particularly since so many of them pay substantial dividends. Hedging a price drop in the commodity helps to offset weakness in the industry’s stocks for any reason, oil-related or not, but oil-price hedging profits often happen on top of capital gains and dividend income achieved in oil equities.

We constantly monitor the price of oil as an economic indicator and for trading opportunities. The commodity’s tendency to settle into a price range makes it a convenient swing-trading vehicle. Leveraged ETFs and other magnifying tools make even small moves involved in reverting to the mean capable of translating into meaningful profits. I believe we're in such an environment now.

In the aforementioned decade of $20 oil, the planet averaged 1,900 operational drilling rigs. The recently higher price of oil has unleashed animal spirits to where oil companies have operated closer to 4,000 rigs for the past three years. More drilling creates more production, of course, and the higher rate of production persists even after the drilling phase. Oil companies are good at dialing back immediate production to limit stockpiles to keep the price high, and that's what they’ve been doing, but overall production is running strong as global demand remains tepid and oil consumption is threatened by the rise of natural gas popularity. These factors are creating downward pressure on the price of oil and it looks destined for a date with at least $80, the low end of its recent price range. From its current $105, a fairly easy drop to $80 represents 24% of downside.

Most of the recent price spike has been about political turmoil in Egypt, but not because Egypt is a critical oil producer. There's a knee-jerk reaction to Middle East disruptions that involves bidding the price of oil higher, with little acknowledgment that the Middle East is in constant turmoil or analyzing current turmoil to assess its real threat to the production and transportation of oil. Egypt produces little of the world's oil, and what it does produce is probably not in danger due to political rumblings. The bigger threat is to shipment of oil and the passage of U.S. warships through the Suez Canal, but neither of these is in danger either.

The Arab Gas Pipeline has been bombed by extremists several times in the past couple of years, but the Egyptian army and police have managed to secure the Suez throughout the chaos. Certainly foreigners, but even Egyptians, are not allowed near the canal without questioning by police. Egypt's economy is in a rut and the mayhem of the past couple of years has reduced its former flood of tourists to a trickle, so you can be sure the last thing it wants is for reliable Suez traffic cash flow to shut down. Egyptian pilots board every vessel passing through the canal to help it navigate the waterway. Worst-case fears of canal passage ending are overblown. This suggests that the Suez spike in oil prices will retreat in the days ahead.

The only other reason oil prices could remain elevated is if demand is going to increase meaningfully due to an acceleration in the global economy. This is doubtful, too. If anything, demand will probably underwhelm. This and the capacity glut mentioned above should maintain downward momentum in the price of oil even beyond the unwinding of the Suez spike.

Therefore, it's wise to position capital to benefit from a reversion of oil prices back to the middle or low end of their recent range. Some analysts think that improving fuel efficiency and ample supply will exert enough pressure to form a new range below $80. If so, a short from here will produce even more profit, but no trading range beyond the one just below current prices is needed for an oil short to work now.

Disclosure: I have no position in XOM.