Crude Oil - A 'Three-Peat'

by: Andrew Hecht


March 2015.

August 2015.

Different, but the same.

Iran vs. Saudi Arabia.

An eventual return to 1986?

For those of you who are basketball aficionados, Pat Riley, the president of the Miami Heat and a former NBA coach, trademarked the term "three-peat" back in 1988. He did so when the team he coached, the Los Angeles Lakers, was competing for their third straight NBA title. However, it was Coach Phil Jackson's team, the Chicago Bulls, that accomplished the "three-peat." The trademark earned Riley over $300,000 in licensing fees. While Riley did not coach the team that won three straight NBA championships, the income came as a consolation prize.

Based on the action in markets last week, it appears that crude oil is now attempting a "three-peat" of its own. The third recovery rally since the bear market in the energy commodity commenced in June 2014 is now underway. One thing is for sure - when it comes to crude oil, this market is volatile, and it is affecting markets across all asset classes.

March 2015

Crude oil peaked at $107.73 per barrel in June 2014. Since then, the price has declined precipitously. The biggest plunge, in nominal terms, came between that month and March 2015, when it hit lows of $42.03.

Crude oil fell an incredible $65.70 per barrel over a 10-month period. Markets rarely move in a straight line, but that time it did. Traders and investors had become accustomed to crude oil prices north of $70; after all, prior to 2014, the last time that the commodity had a sixty handle was back in the early summer of 2010.

OPEC, the oil cartel, convened in November 2015, and the market expectations were for the oil ministers to respond to a falling oil price, which was approaching the "low" level of $75 per barrel. The response of OPEC was not what the market wanted. In an effort to force low-cost production out of the market, the cartel said they would not cut output with the intention of gaining market share by flexing their production muscles. In the wake of that meeting, the price of oil plunged; it fell through $70, then $60 and $50 a barrel. As the price approached the $40 level, analysts panicked. One well-known commodity pundit on a major financial news network said that crude oil would go the way of whale oil and fall to $10 per barrel.

As often happens in markets, when the calls for disaster get loudest, the lows are not far off. This was the case in March 2015, when crude oil futures fell to $42.03 and quickly reversed. The price of the energy commodity rallied over the following nine weeks, peaking at $62.58 during the first week of May. OPEC meets every six months to establish production policy. According to its mission statement, OPEC's focus is to "ensure the stabilization of oil markets in order to secure and efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry." While prices had plunged to just over $40 in March, by the time of the next meeting in June, the price was hovering on either side of $60 per barrel.

The ministers must have thought they weathered the storm of lower prices. That now they would reap the benefits as the highest-cost producers would fall by the wayside. One signal that gave them hope was that rig counts in the United States declined alongside prices; surely, production would follow. Therefore, at their next meeting, the ministers of OPEC stated that production policy would remain unchanged.

August 2015

During the week of March 16, 2015, oil peaked at $62.58 per barrel. In the wake of no action by OPEC in June, the weak market got weaker. The falling price of oil was a supply issue leading up to the June OPEC meeting. However, although demand remained buoyant, fears of demand destruction from a lethargic global economy and an economic slowdown in China added insult to injury for the price of crude oil. Crude proceeded to fall like a stone once again. During the second week of August, the energy commodity fell below the March lows at $42. Later that month, on August 24, when the Chinese devalued their currency in a move that shocked the world, the price fell to new lows at $37.75 per barrel.

The bears returned to the airwaves and the printed pages. Calls for sub-$30 crude were the norm rather than the exception. While the price of NYMEX WTI crude fell hard over the past months, the price of Brent crude - the benchmark pricing mechanism for Middle Eastern crude - fell more. The premium of Brent over WTI, which had been in place since the Arab Spring in 2010, declined, and the prices of the two crudes converged.

At the same time, a nuclear non-proliferation agreement with Iran became a reality, and the OPEC member would now be free to sell even more oil into the market. The cartel's production ceiling was at 30 million barrels per day, but members were selling more than 31.5 million. With no sanctions, future Iranian sales would now move that number even higher.

It did not take long for the price of crude oil to bounce after August 24. The first bounce from $42.03 in March to over $62 took nine weeks. The second bounce - the recovery from $37.75 in late August - took crude oil to $50.92 by the first week of October. The five-week rally was intense; it decimated those with short positions and left analysts pondering the next move. The next meeting of OPEC was on December 4, 2015. Instead of holding above the $50 level, the price started to move lower once again. By the time ministers sat down in Vienna, the price was around $40.

Different, but the same

At $40 per barrel, the poorer members of the cartel began lobbying for production cuts. An early signal that this was not on the horizon was a meeting of the board of governors of the cartel, which generally makes policy recommendations to the membership. At that meeting in the weeks before the formal pow-wow, there were no decisions about anything. Any policy initiatives were "tabled" until 2016. The strongest members of the cartel were at odds, and not just about oil - about everything. Iran and Saudi Arabia were at odds, resulting in military action and a proxy war in Yemen, which had recently been subject to a coup d'état by Shiite, Iranian-backed rebels. Saudi Arabia shares a long border with Yemen, and they viewed the coup as a threat to their national security and the power of the royal family.

At the December 4 meeting, the ministers basically threw up their hands and told the world that other major producing countries like Russia and the United States had no production ceiling, so why should they? Iran stated that regardless of OPEC policy, they would be increasing daily production by 500,000 to one million barrels per day. The nation stated that selling oil is their sovereign right. The price of crude oil plunged, breaking support at $37.75 in early December, and falling to lows of $26.19 per barrel on January 19.

Since then, the price has recovered, and that recovery is starting to look a lot like a "three-peat." By Friday, January 29, active-month March NYMEX crude oil futures closed at $33.62, trading to highs of $34.40 on the session. On Thursday, rumors of a production cut caused the price to move higher, reaching the week's apex at $34.58. Given the dominant players involved - Russia, Iran and Saudi Arabia - it is highly unlikely that we will see lower output anytime soon. March lows took crude from $42.03 to $62.58 - an increase of 48.9%. The August lows at $37.75 gave way to October highs at $50.92 - an increase of 35%. Now, after the recent lows at just over $26 per barrel and Thursday's highs, crude oil has recovered by around 33%. This qualifies for the third leg of the "three-peat" for crude oil. The question now becomes: What is next?

Iran vs. Saudi Arabia

The relationship between Iran and Saudi Arabia is complicated. There have been shifts in the power base of the Middle East over recent months. The nuclear non-proliferation agreement with Iran resulted in a détente of sorts between the theocracy and the United States and Europe. Meanwhile, it has weakened ties between the Saudis and their traditional allies in Europe and America. The proxy war rages on in Yemen. During the New Year weekend, the Saudis carried out a death sentence on a high-profile Shiite cleric. Iran responded by setting fire to the Saudi embassy in Iran. The Saudis expelled the Iranian diplomats in Riyadh. Saudi allies, Kuwait and the UAE, severed diplomatic ties with Tehran. As the political temperature in the Middle East rose, the price of oil slumped.

I believe that the war of words and action (in Yemen) has resulted in Iran and Saudi Arabia using crude oil as a weapon of war against one another. From the Saudi perspective, lower crude prices will continue to choke Iran with economic pressures. Saudi Arabia is the biggest oil producer in the world, with daily output of over 10 million barrels at a very low cost of production. They believe that they can outlast the Iranians in a prolonged bear market for crude oil. Therefore, the Saudis seem to be taking the position that lower oil is an effective weapon against the hostile government of Iran.

Meanwhile, the Iranians could be looking at things in an entirely different light. Iran is used to living under sanctions. They are accustomed to economic hardship. After all, the nation has been living as a pariah since the late 1970s, when they held American diplomats hostage at the beginning of the Islamic revolution. Iran could figure that the Saudis are used to living high on the hog, and sky-high oil prices over recent years have spoiled not only the royal family, but also the citizens of the kingdom. There are signs that Iran could be right in this assumption. Over recent months, Saudi Arabia has borrowed in the international debt markets for the first time in many years. They have increased domestic energy prices, experienced increasing military expenditures given the war in Yemen and the war against terrorism, and they have even began talking about selling off and privatizing a part of the crown jewel and cash cow of the kingdom, Aramco. Moreover, the death of the Saudi King last year and the installation of a new monarch gives Iran a chance to test the new and less experienced leadership at a time when the Iranian theocracy's ties to Russia and even the U.S. and Europe have never been stronger, and the Saudis' relationships have never been weaker. Iran could be figuring that the citizenry of the kingdom will eventually rise up against the royals.

The bottom line is that economic hardship is a new experience for the Saudis, while it is old hat for Iran. Even though Saudi Arabia produces more than twice the amount of oil, the royal family's grip on the nation's citizenship could slip under the threat of growing Iranian influence in the Middle East. Lest we forget, Saudi Arabia is home to two of the most holy sites in the Islamic world. The theocracy would like nothing more than to get its hands on and control of Mecca and Medina.

At this point, the relationship and trust between Iran and Saudi Arabia has deteriorated to a point where it is hard to imagine representatives of the two countries sitting down in the same room, even if it is at an OPEC meeting. The chances of them agreeing on anything are a pipe dream. This could mean that all bets are off, and both nations will flood the market with oil in 2016. Remember, the lower the price of the energy commodity goes, the only way to achieve revenue is to sell more for many OPEC members, including the two that are at odds thinking they will damage the other by forcing the price even lower.

An eventual return to 1986?

Last week, the American Petroleum Institute reported the biggest weekly increase in inventories since 1996 - adding 11.4 million more barrels to stockpiles. Although oil showed signs of life this week, the reason it has plunged since June 2014 is that the world is awash in the energy commodity. Last week's inventory report is just another reminder of huge supplies that have weighed on price in the U.S.

In the Middle East, output continues to flow unabated. In 1986, the Saudis flooded the international markets with oil. In that year, the price fell to a level under $10 per barrel.

During the spring of 1986, crude oil reached its nadir at $9.75 per barrel. Today, supplies abound. While rig counts in the U.S. have fallen from over 1223 last year to 498 in operation last week, according to Baker Hughes, production continues to flow at the 9 million barrel per day level. Inventories are building in the U.S. despite the ability to export oil granted by an act of Congress in 2015. Russia has expressed no interest in curtailing oil production. When Russia became the subject of sanctions over the situation in Ukraine, they quickly agreed to supply China with cheap crude oil. Russia continues to produce at the 10 million barrel per day level. OPEC daily production is currently around 32 million barrels per day, but you can bet your bottom dollar it will move higher than that the lower the price goes. The fundamental prospects for crude oil are ugly right now, reminiscent of 1986, in fact. However, what is making those prospects ugliest - supplies - will likely be the thing that propels them higher in the future.

The fact is that more than half the world's oil reserves are located in the Middle East. The other fact is that this is hardly a stable region. Any military action, terrorist or otherwise, that affects oil production, refining or logistical routes in the region will cause the price of crude oil to rally to the ferocious degree that we have not seen since the early 1990s with the Iraq-Kuwait issue. Meanwhile, the current state of the oil market means that volatility is here to stay. Right now, it looks like oil is undergoing a "three-peat" - its third recovery in the bear market that began in 2014. Oil is a complicated commodity; there is more than meets the eye when it comes to the price. Analysts are bearishly intoxicated with supply these days; demand is growing by virtue of world demographics. No one knows how high the current recovery will take crude oil or whether it will make another new low. The supply situation in the world and actions of dominant producers seems to favor the later.

Lower oil means that we consumers get what amounts to a tax break - more discretionary spending money. However, we need to be cognizant that lower oil will make the temperature in the Middle East rise as the flow of capital slows, and economic hardship is likely to breed discontent in what has been relatively stable nations. In this age of terrorism, that is a frightening prospect for the world.

As a bonus, I have prepared a video on my website, Commodix, that provides a more in-depth and detailed analysis on energy and equity markets to illustrate the real value implications and opportunities.

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.

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