It's Time To Short Oil

Includes: DNO, DTO
by: Oil & Energy Daily

It's gotten to the point that the oil market is thoroughly out of whack, and it's time to short it.

The signs are everywhere…

  • There's sluggish economic growth across the board - and little stimulus ammunition (or political will) left to fight it.
  • Supplies are high. (OPEC is currently producing almost two million barrels per day (bpd) more than the market needs, so the level of oversupply is expected to remain above one million bpd for the rest of the year, according to the IEA.)
  • Geopolitical turmoil in the Middle East has artificially inflated prices.
  • And, most importantly, the end of expansive monetary policy in the United States is looming on the horizon.

Indeed, at $105 per barrel, oil is way overpriced. And it won't be long before you see it slump back down to $90, $80, or even $75 per barrel.

Here's why…

Political Pomp

Oil prices are up 10.5% over the past three weeks. And it's not because demand is strong or because supplies are dwindling. It's because chaos broke out in the Middle East.

The United States honored its promise to arm Syrian rebels after the regime used chemical weapons on its own people. And Egypt's military forcibly ousted its president-turned-dictator, Mohamed Morsi.

However, neither Egypt nor Syria is a major oil producer. And the only major transport hub between the two is the Suez Canal, which was never in any real danger. So their influence on the physical oil market is negligible. It's purely psychological.

What's more is, while these two conflicts are either peaking or plateauing, the other major political disruption in the region is likely winding down.

I'm talking about the Iran sanctions.

Not only is Iran a key global producer, but it actually does have control over a major transport hub - the Strait of Hormuz. If you recall, after being heavily sanctioned by the United States, Iran threatened to shut the strait down, an act that would shock the global economy and roil energy markets. That drove oil prices much higher.

However, that threat was never fulfilled, and it doesn't look like it ever will be. To the contrary, the country's political leadership appears to be heading in the opposite direction. Last month, Iranians voted overwhelmingly to elect Hassan Rohani as president - a moderate who advocates greater personal freedoms and a more conciliatory approach to the world.

Now, this alone doesn't signal an immediate end to the hostilities, but it's a good start. Rohani served as the lead nuclear negotiator under an earlier reformist president, Mohammad Khatami. Khatami froze Iran's nuclear program, eased social restrictions and promoted dialogue with the West.

So this could be the beginning of the end. It's certainly a huge improvement over Iran's last president, Mahmoud Ahmadinejad - a holocaust denier who routinely threatened to annihilate Israel.

If Iran comes back into the fold, 3.3 million barrels of oil a day will pour into the global market, adding to the oversupply that already exists.

That's bearish for oil prices.

Now, let's talk U.S. politics…

The Window is Closing

Just prior to this whole Syria/Egypt kerfuffle, oil prices had slumped to a four-month low of about $86 per barrel - down from the mid-to-high $90s where they started the year.

And why?

Because the U.S. Federal Reserve was signaling an end to expansive monetary policy. The message got so blatant in June that the Dow and S&P 500 each shed about 3% in just three days. Since then, Federal Reserve Chairman, Ben Bernanke, has dialed down the rhetoric, and some weak economic data has allayed investor concerns that the punch bowl will be taken away.

But here's the thing: The punch bowl will eventually be taken away. Maybe not today, and maybe not tomorrow, but soon. And we're going to see a much steeper decline in both stocks and commodities, as a result.

As it pertains to the energy market, U.S. growth isn't strong enough to significantly increase oil demand, nor is it weak enough to warrant a collapse in prices. And the second U.S. growth is strong enough to drive energy demand significantly higher, it will mean the economy is strong enough to withstand the withdrawal of stimulus.

So even if U.S. oil demand does pick up, that will actually have a negative impact on oil prices.

Bottom line: Oil prices will moderate in the short-term - likely sliding back down to the $90s - as the geopolitical forces behind the recent surge are recognized as overblown. They'll stay there, until global growth comes completely unglued - or, more likely, until the Fed makes a serious move to rein in stimulus.

Once that happens, oil prices will move to a more reasonable level of $80 to $85 per barrel.

It's possible that China will act to stimulate its own economy, but that would only offer short-term support to oil prices. The same is true of any decision by OPEC to curtail supply - something the cartel hasn't yet come close to doing.

So given the short-, medium- and long-term threats, shorting oil is a pretty safe bet.

To that end, rather than dabble in the risky options market, you might consider picking up an ETF such as the PowerShares DB Crude Oil Double Short ETN (NYSEARCA:DTO) or the U.S. Short Oil Fund (NYSEARCA:DNO).

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.