Crude Oil In A Pressure Cooker

by: Andrew Hecht


A new low and handle.

Location/Quality spreads - bearish.

Term Structure - bearish.

Products - bearish.

The lower it goes.

oil 2016 One of the biggest stories in markets in 2015 was the decline in the price of crude oil. In 2016, that story has intensified. Fundamentals or supply and demand characteristics influence the price of crude oil, as do geopolitical considerations. Half of the reserves of the energy commodity are located in perhaps the most turbulent region in the world, the Middle East.

Since 2014, rising world production has created a condition of oversupply and prices have gone south. Slowing economies around the world, particularly in China, have dented the demand side of the equation at a time when supplies have been rising. This has caused the price of oil to drop.

A lower oil price is good news for those businesses that rely on the energy commodity as a key cost of goods sold input. Airlines, for example, have seen their profits grow as their energy costs have decreased. For individuals, lower oil amounts to a tax cut. When it costs less to fill up our cars at the gas station or heat our homes, monthly expenditures drop and we wind up with more discretionary income. On one side of the coin, a lower oil price is stimulative for consuming nations, many businesses and individuals alike. However, lower oil has had a negative effect on many other aspects of financial and even political life around the world.

For producing nations, an oil price that has declined by over 70% in a year and a half has been a disaster. The world's largest producer of crude oil, Saudi Arabia, has had to resort to debt markets to borrow money for the first time since 2007. The Saudis have cut social programs, raised domestic energy prices and are considering privatization of their state oil company, Aramco. All of these initiatives designed to raise money. While the production cost of oil in the Kingdom is the lowest in the world, they had become accustomed to the cash flow of years past. A sudden halt in those petrodollars has also come at a time when another nation in the region is flexing its newly minted power.

Iran is used to living under difficult economic conditions. Decades of sanctions and isolation are lifting and the theocracy has lots of cash coming in by virtue of a nuclear nonproliferation deal consummated in 2015. At the same time, Iran will be increasing oil production, which will not only bring more money into Iran but also serve as an economic weapon against their enemies, the Saudis. The proxy war in Yemen between the two nations is further evidence of the vitriol. The Saudis may believe that a lower oil price will harm Iran and the Iranians may think the same about the Saudis. Both nations appear to be selling crude oil with abandon.

The falling price of oil, concerns about slow economic growth in China, European economic lethargy, fears of global terrorism and a relatively strong U.S. dollar with rising short-term U.S. interest rates has caused a contagious effect on equity markets. The major indices in the U.S. have had a miserable start to 2016. The major indices contain many energy companies that are suffering under the weight of lower oil. Lower equity prices hit home in terms of individual investors and savers. While individuals are reaping the benefits of lower oil with more discretionary income, their investment accounts may be sinking even more.

World markets are in a pressure cooker and the lower oil goes the more pressure the world will feel. Crude oil itself is in that pressure chamber, the lower it goes the more likely it becomes that events in the Middle East will cause increasing volatility in the energy commodity. Right now, the outlook for the price of oil remains ugly.

A new low and handle

The price of crude oil has been a falling knife. This has been the case for a year and a half but during that period, there has been some wild volatility. When the price first fell to $42 last March, a sharp, nine-week recovery rally took the price north of $60 before selling returned to the market. In late August, when the Chinese shocked markets and devalued the yuan, crude oil made yet another lower low when it traded to $37.75. A short and vicious rally followed, taking the price to over $50 per barrel. Since then it has been a one-way street. In the wake of the last OPEC meeting in early December, oil broke down below the August lows. During the first two weeks of 2016, crude oil continued to plunge. During the first week of the year, it fell below the December 2008 lows and key support at $32.48. During the second week, the $30 level gave way and NYMEX active month crude oil settled last Friday at $29.42 per barrel. It traded to lows of $29.13 during the session, which was the lowest price since November 2003.

The monthly chart of crude oil says it all. In 2014, crude oil fell by $45.15 per barrel or 46%. In 2015, the price shed another $16.23 or 30%. So far, in 2016, the price is down another $7.62 or 21%. Since the beginning of 2015, crude oil has dropped $69 per barrel - the current price of $29.42 amounts to less than half the value of the price drop.

Meanwhile, the price recoveries in March and August provide a reason to pause given the recent action in the crude price. However, the world continues to be awash in crude and market structure points to an even lower price.

Location/Quality spreads - bearish

Six years ago the Arab Spring that began in Tunisia and spread to Libya, Egypt and the rest of the Middle East caused the political premium on crude oil to rise. The most direct effect on the energy commodity occurred in the location/quality spread between Brent crude oil and West Texas Intermediate crude. While WTI is the pricing mechanism for North American crude, Middle Eastern crudes depend on the Brent benchmark for pricing. The spread rose to a premium of over $25 for Brent over WTI following the Arab Spring.

The premium for Brent represented the political risk of changing governments in the region. It also represented concerns about the status and availability of key logistical shipping lanes in the region such as the Persian Gulf, Straits of Hormuz and Gulf of Aden. Over recent years, that Brent premium has decreased as world production and supplies swelled. In early 2016, the Brent premium disappeared and this aspect of market structure in crude oil returned to its long-term normal state, which is a premium for WTI. NYMEX WTI crude oil is sweeter crude, which means it has lower sulfur content. This makes it cheaper and easier to refine into the most ubiquitous oil product in the world, gasoline.

Last week Brent crude oil futures rolled to March and the Brent versus WTI March spread closed at the $1.45 per barrel level, with WTI trading at a premium to Brent. In my opinion, this is a bearish signal for crude oil as the political premium for crude has evaporated under the weight of enormous world supplies.

Term Structure - bearish

When it comes to understanding the fundamental supply and demand equation for any commodity, term structure or the forward price curve provides some of the best data on whether a glut or deficit condition exists. On Friday, January 15, 2015, the February 2016 versus February 2017 NYMEX crude oil spread was trading at around the $7.37 per barrel level.

February 2017 was trading at a premium to the nearby crude. This premium in the crude oil market equates to a 25% contango. This tells us that supply is greater than demand and the market remains bearish. Brent crude oil one year spreads, the March 2016 versus March 2017 futures contracts, were trading at even a higher contango late last week as the market anticipates more oil flows from Iran.

The term structure in crude oil continues to support lower prices.

Products - bearish

Consumers do not buy raw crude oil; they buy oil products like gasoline, heating oil, jet fuel and other petroleum products processed from raw crude oil. This processing or cracking of crude oil takes place in a refinery. Therefore, crack spreads are a real time indicator of the economics of refining crude oil. Strength in crack spreads is a sign of demand, while weakness in these spreads means that demand is weak or inventories are too high.

Earlier this winter the price of gasoline was strong against the price of crude oil. This was because a combination of low seasonal inventories, low prices and a warm start to winter caused an increase in miles driven by consumers. The active month gasoline crack spread hit highs of $19.42 per barrel during the week of December 14, 2015.

As of last Friday, the gasoline crack spread fell to $13.47 per barrel indicating weaker demand for gasoline, rising inventories or a combination of both. Gasoline closed last Friday at around $1.03 per gallon wholesale on the active month February NYMEX futures contract. The action in the crack spread tells is that gasoline demand has weakened.

Heating oil has been another story, that oil product has been trading at the weakest level in many years. Last week the price of active month February heating oil fell to the lowest level since April 2004.

As the monthly heating oil chart illustrates, the price of heating oil futures fell below $1 per gallon last week and closed the week just below 94 cents per gallon wholesale. The monthly chart for the heating oil processing or crack spread shows that the economics for refining have deteriorated along with the price of the oil product.

On Friday, January 15, the heating oil crack spread was trading at $9.82 per barrel, the lowest level since August 2010. As this is a seasonal product spread, the last time that it traded this low in January was in 2010.

Both the gasoline and heating oil crack spreads indicate a combination of weak demand and high levels of inventories. As supply and demand fundamentals for oil products eventually filter back to the fundamentals for raw crude oil, the current state of the oil product markets tell us that the picture remains bearish.

The lower it goes...

It is a bleak picture for crude oil, which has already fallen to the lowest level since 2003. The next area of support is the April 2003 lows of $25 per barrel and below there the 2001 lows of $16.70 come into play. However, fundamentals are only one part of the picture for crude oil; the geopolitical risks in the Middle East are currently at the highest level in years.

I believe that lower oil favors Iran over the Saudis given the Iranian ability to survive under negative economic conditions for decades. This is likely to result in Iranian sales of the energy commodity as a tool in the conflict between the two nations.

Crude oil is in freefall, picking a bottom is a dangerous game. The lower it goes, the more that pressure will build in the oil market. The Middle East will continue to be an area of the world most likely to present violent and game changing surprises in 2016. I expect some wild volatility in crude oil throughout the year. At over a 25% one-year contango on Brent and WTI, buying nearby crude and selling deferred could be an incredible opportunity this year. Now that the price is below $30, surprises are likely to come on the upside. The damage in oil over the first two weeks of 2016 has been nothing short of amazing - crude oil is already down over 20% this year. It dropped 30% in all of 2015. It could be a time to start buying some call options on the energy commodity soon, when you buy an option all that is at risk is the premium that you pay. Oil is in a pressure cooker and the price action in 2016 is reverberating through all markets around the world. Fasten your seat belts; there is a wild ride ahead.

I have prepared a video on my website, which augments this article and provides a more in-depth, detailed analysis on the current state of the crude oil market to illustrate and highlight the real value implications and opportunities available.

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.