Oil Will Continue Lower On Increasing Supply And Decreasing Demand

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Includes: OIL
by: D. H. Taylor

Summary

OPEC failed to cut longer-term production levels, and oil has been dropping hard.

I'm out of an earlier short position, but looking to go short for larger move lower.

The long-term economic outlook would mean lower demand for oil, with a slowing U.S. economy and a Chinese economy on the precipice.

Oil took a dive this week. I had been expecting that; I went short the day before the OPEC meeting in what was called by others a laughable move. Now I'm laughing. Oil had dropped from about $52.50 to where it is now, $45.50. The week saw a strike in Libya at their largest oil field that produces about 275k bbl/day. That strike was resolved and oil got drilled. I expect a lot more moves lower in oil, but first a modest move upward simply because of the excessive and sharp move lower.

Everyone had expected OPEC to pull together and extend their oil production cuts beyond their original intention, as well as cut even more. That is exactly the point at which I started to laugh. Oil had rallied on this expectation.
WTI showing oil heading lower
OPEC originally planned on cutting 1.2 million bbl/day. They achieved cutting 900k bbl/day. That is notable, for sure. But they missed that original mark. Let me repeat what everyone was expecting because it bears repeating: Everyone expected OPEC to make a deeper production cut for an extended period of time. The members of OPEC could not even hit their first objective, so how are they going to cut more for a longer period of time? OPEC members could not agree on deeper cuts, nor could they agree on an extension of the time frame.

The reason I was short in the first place was that I am bearish on oil altogether. The U.S. continues to add more and more rigs to its production levels. The U.S. oil industry just printed a record 21 weeks straight of increasing rigs, as an additional 11 rigs were added to total production. Who knows how much oil each of these rigs will produce individually. After all, 11 new rigs does not merit an entire inventory of production, or even a tiny portion of that. The total rig count now stands at 927 in the U.S., 132 in Canada and 957 internationally.

But, on aggregate, the U.S. and Canada, who collectively produce about 14% of the world’s oil, continues to add more and more production and oil. Eight additional rigs here, 11 new rigs there and after awhile you are talking about production levels that add up. That is exactly what North American oil companies are doing:

U.S. Crude Oil Production Canada oil production on the rise
Looking at the charts, the U.S. still has a lot of catching up to do to its highest level of oil production activity. If America can hit those levels, this would entirely negate what OPEC is cutting. For now, the U.S. and Canada are merely reducing the effects of OPEC's cuts by about 35%. OPEC is cutting about 900k bbl/day, while the U.S. and Canada are adding approximately additional 250 bbl/day.

This brings in the next part of the equation, the demand side. The U.S. is slowing, although the Federal Reserve sees this as being transitory. They do not believe the economy will slow noticeably. I think that is laughable. Headlines have been printed about delinquency rates heading higher for loans on credit cards, automobiles, student loans and home loans. Lenders are starting to contract by having to set aside funds for loan loss contingencies. Personal incomes are lingering in slow-motion. I can't even remember the last time anything meaningful was mentioned about infrastructure spending, which potentially could give the economy a shot in the arm to push it forward.

Then there is China. The world's No. 2 economy is faltering. The economy is seeing a slowing in its manufacturing, as well as the effects of the government cracking down on its 30% zombie loans situation. All this and the country's oil production is heading upward, and people actually think oil prices are heading higher?

For now, I see the move being a bit strong and am looking for a price level to go short on oil once again. I am building up an options position, but am waiting for a better price level to go short. Oil came down fairly quickly over the past few days, and I expect there will be a moderation in price the next couple of days.

WTI is trading about $45.50 right now. If I see a range of $47.50-$48.50 over the next seven trading days, I will take the short position with a buy on the $50.00 call for two months out. With an out-of-the-money call, low delta, if the strike hits, I can take a profit on the options position that will offset the decline on the short spot position. I will also go 2x on the options size in case something unexpected occurs that would drive up the price of oil unexpectedly. However, I see no ability of the world economies to turn around and all of a sudden demand more oil, nor OPEC changing its mind and cutting more oil and the U.S. turning around and dropping its production levels.

Those variables, on the aggregate, are the reasons why oil is decreasing in price. Until there is a fundamental change in oil supply and demand, oil prices will head lower.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in OI over 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.

Additional disclosure: I am shorting WTI via an options position