3 Reasons Oil Should Head Back To $50

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, USOI, UWT, WTID, WTIU
by: Andrew Hecht

Summary

An ugly June for crude oil.

The OPEC announcement and higher inventories pushed the price lower.

Reason one: The biggest IPO in history and tension in the Middle East.

Reason two: Russian and U.S. vested interest.

Reason three: Global demand.

In many ways, crude oil is the most significant commodity in the world. Despite technological advances over recent years, crude oil still powers the world and consumption of the energy commodity is ubiquitous. The price of crude oil is partially a function of global economic growth. As conditions improve, energy demand tends to rise, and during periods of contraction, demand falls.

Meanwhile, it is the supply side of the fundamental equation for crude oil that often injects the market with price volatility. A large percentage of the world's reserves of oil are in the Middle East, the world's most turbulent region. If it were just a simple supply and demand calculation that determined the price of oil the price would fall to an equilibrium level which these days would likely be lower than the current market price. Ah, if life were so easy.

Crude oil is a political and economic tool and its price at any time is the result of a myriad of factors. The nations around the world that produce the energy commodity spend lots of attempting to influence the price, and over the coming months, the chances are that the three leading producers will succeed.

An ugly June for crude oil

It has been an ugly June for crude oil as the energy commodity could not hold above the $50 per barrel level. Source: CQG

As the daily chart of July NYMEX crude oil futures highlights, the price of the energy commodity has been making lower highs since the very beginning of 2017 when the July crude traded at its highs for the year at $58.15 per barrel. The most recent high came on May 25 at $52, and since then the price dropped to a low of $44.54 just $0.78 above the lows so far in 2017 at $43.76 established at the start of May.

Crude oil futures settled on Wednesday, June 14 at $44.73 per barrel, a lot closer to the bottom end of this year's trading range than the top. Crude oil had moved to the downside recently in the wake of the May 25 OPEC meeting when the cartel announced they would extend their production cuts through the first quarter of 2018. At the same time, increasing production in the U.S. has led to higher inventories of oil products which has weighed on the price of the energy commodity. Source: CQG

As the weekly chart illustrates, nearby NYMEX crude oil futures have traded from lows of $43.76 to highs of $55.24 throughout the first five and one-half months of this year. Moreover, NYMEX crude oil has spent most of the time in 2017 above the $50 per barrel level which stands as a pivot point. The average price on the weekly chart so far this year has been $49.50 which is just 50 cents below the half century mark.

The OPEC announcement and higher inventories pushed the price lower

Crude oil fell below $50 per barrel on May 25 immediately after the announcement that OPEC would extend their output policy and quotas to the end of the first quarter of 2018. The oil market had hoped for an increase in cuts and an extension of the time horizon for the status quo since the start of 2017 when it comes to production was not enough to hold the price. At the same time, the higher price of crude oil over the course of 2017 had caused an increase in production from shale regions in the United States. This week inventories of crude oil rose by 2.75 million barrels according to the API and the EIA said they only fell by 1.66 million, less than market expectations. Additionally, gasoline inventories at the start of the driving season have been increasing. The latest projections from the Energy Information Administration have told the market that total U.S. output could rise to above the 10 million barrel per day level in 2018 if the price of oil holds around the $50 per barrel level. The ten million barrel level per day would put the U.S. in an exclusive club with the two other major world producers, Russia and Saudi Arabia.

It seems like analysts turn bullish on rallies and bearish on dips these days as the price of the energy commodity rises and falls. When oil recovers above the $50 per barrel level, many analysts point to growing global demand for the energy commodity and the OPEC production cuts. As the price falls below the pivot point price, attention shifts to U.S. shale production, the rise of alternative energy sources, and increasing inventories. While arguments on both sides are compelling, I believe that the price of oil will continue to trade in a range where $50 per barrel serves as the pivot point into 2018, and three reasons support a return of NYMEX nearby futures to that level sooner rather than later.

Reason one: The biggest IPO in history and tension in the Middle East

Sometime in 2018, Saudi Arabia intends to inject a significant amount of capital into their sovereign wealth fund with an initial public offering of the Kingdom's crown jewel. Saudi Aramco is the state oil producing company, and the IPO is likely to be the biggest in history with the business's valuation bumping up against the one trillion dollar level. In their Vision 2030, King Salman and the Royal Family have expressed a desire to diversify the nation's economy away from dependence on petroleum revenues. The Saudis have stated they intend to sell a 5% stake in Aramco, but a successful IPO could lead to the sale of an even bigger stake. With the daily production at over 10 million barrels of crude oil each day, the Saudis are a powerhouse when it comes to supplying the energy commodity to the world. The massive production comes with influence in the oil market, and for many years Saudi Arabia has steered the policy for OPEC. When oil fell from over $107 per barrel during the second half of 2014, it was the Saudi's strategy to flood the market with oil to build market share at lower prices. However, the Saudis abandoned that course as shale output continued to flow from North America. The Kingdom shifted its attention to the IPO and diversification in 2016 leading to OPEC's announcement of a production cut and quotas in late 2016. The Saudis have a vested interest in maintaining the price of oil at the $50 per barrel level as their IPO approaches. A stable price for the energy commodity around its current pivot point will likely enhance the proceeds from the sale of shares in the soon to be publicly traded company. The Aramco IPO is a significant reason for crude oil to continue trading around its current pivot point.

Recent developments in the Middle East have increased the political temperature in the region. Last week, the Saudis and their allies announced that they would sever diplomatic ties with Qatar. The move resulted in air, sea, and land blockades of the tiny nation that sits strategically in the Persian Gulf. Qatar had long played a critical role in OPEC as the country served as a mediator between the Saudis and Iran, arch enemies in the region. However, last year the Russians became involved as a go-between and that diminished Qatar's purpose and role. After a recent visit to Saudi Arabia by U.S. President Donald J. Trump, the Saudis announced that they would no longer tolerate Qatar's warm relationship with Iran nor would they stand silently while Qatar provided funding for terrorist organizations in the Middle East. The move by Saudi Arabia is probably an effort to bring Qatar back into the fold and a dose of tough love for their former ally in the area. Meanwhile, the move could serve to destabilize the region. On the one hand, if the Qataris dig in their heels and become closer to Iran, their neighbor on the other side of the Gulf, a larger rift within OPEC is likely to develop which could threaten production cuts which could send the price of oil lower as members abandon quotas and increase output. Qatar and Iran are significant producers of oil and natural gas in the region. The blockade has caused mounting pressure on Qatar as they depend on the Saudis for over 40% of their food and many other supplies. Iran has quickly begun to send supplies to the tiny nation to increase their influence. The longer the blockade goes on, the wider the political rift in the region will become. On the other hand, any increase in violence caused by the growing rift in the area could threaten oil production and refining infrastructure as well as logistical routes, most specifically in the Persian Gulf. Therefore, a continuation of the current political situation in the Middle East could be slightly bearish if OPEC falls apart but it could also lead to price spikes if oil production or transportation routes become targets of violence in the region. I view both the Saudi IPO of Aramco and the blockade of Qatar as supportive of a return to the $50 per barrel level for crude oil over the weeks and months ahead.

Reason two: Russian and U.S. vested interest

Alongside the Saudis, Russia and the United States are the two other 800-pound gorillas in the world when it comes to crude oil production. Russia depends on petroleum revenues for economic survival, particularly these days as the nation continues to suffer under the weight of sanctions from Western Europe and the United States. When it comes to the U.S., the country is new on the scene as a top producer with daily output rivaling KSA and Russia. Technological advances in drilling and fracking and fewer regulations under the Trump Administration have lowered the cost of production over recent years in the United States. The U.S. has become a swing producer. When the price rises above $50 per barrel, producers have been using the futures market to hedge output ensuring economic survival future. Source: CQG

As the monthly chart highlights, open interest or the number of open long and short positions in the NYMEX crude oil futures market has risen to a record level over recent months. The increase in the number of positions is likely the result of increased hedging activity by shale producers. If the price moves back above the $50 per barrel level, the chances are that these producers will continue to hedge their future output. However, on price dips towards the $40 per barrel level, it is likely that these entities will repurchase hedges, allow projects to lay dormant until the price recovers back to an economic level and the U.S. will take advantage of the lower price by increasing imports of the energy commodity. Therefore, the technological advances and discoveries in the shale regions of the United States have created an environment of turnkey energy independence for America. When the price is above $50, the U.S. will have the ability to join Russia and Saudi Arabia as a 10 million barrel per day producer. When the price falls back towards $40 per barrel, the U.S. will avail itself of cheaper oil from other producing nations of the world.

Russia and the United States have a vested interest in a $50 per barrel price for crude oil. The Russians from a cash flow perspective and the Americans from a production perceptive. I have been writing that I believe $50 is a sweet spot for NYMEX sweet crude oil. It is a price where both producers and consumers can find a degree of satisfaction. After watching oil drop to lows of $26.05 per barrel on February 11, 2016, the sweet spot price is almost double the level seen some sixteen months ago. When it comes to consumers, $50 is half the price seen in June 2014 when the price was trading at over $107 and much less than the 2008 highs at almost $150 per barrel.

Reason three: Global demand and technical signs

The world suffered from an economic meltdown in 2008 as the housing crisis in the United States and sovereign debt crisis in Europe caused a great recession. Central banks lowered interest rates and instituted policies of quantitative easing to inhibit saving and stimulate borrowing and spending. U.S. short-term rates dropped to zero and European and Japanese rates remain at negative forty basis points. Even though the Fed Funds rate is at the 1.25% level these days rates are historically low. Meanwhile, China and the rest of Asia have suffered from an economic slowdown over recent years as double-digit growth in China has become a thing of the past.

However, moderate economic growth in the United States and signs of economic recovery in Europe mean that conditions have improved in the two areas of the world and consumption of energy is likely to continue to increase alongside the rebound in economies. At the same time, better conditions in the U.S. and Europe could have a knock-on effect for the Chinese economy in the months and years ahead. The current trajectory of economic recovery around the world is supportive for crude oil and oil product demand which is another reason why oil should gravitate back towards the $50 per barrel pivot point.

Finally, on a short term basis, crude oil has declined into oversold territory. Source: CQG

As the daily chart of July NYMEX crude oil futures shows, the momentum indicator has fallen into oversold territory, and has crossed to the upside and could be pointing to a rebound in the price of oil. At the same time, increasing inventories of gasoline and distillates have led crack spreads lower over recent weeks; we could soon see a pickup in the refining spreads. Source: CQG

We are now in peak driving season in the United States, the time of the year for peak gasoline demand. The daily chart of the gasoline refining spread illustrates that it had declined from highs of $19.19 on June 1 to lows of $15.29 per barrel on June 14. Support for the gasoline crack spread is around $14.95, the May 1 lows but since we are at the beginning of the driving season, the chances are that we will hold close to recent lows. The API reported an increase of 1.794 million while the EIA said they rose by 2.1 million barrels of gasoline in inventories and higher stocks continue to weigh on the price of gasoline and the crack spread. Source: CQG

Heating oil cracks spreads have declined from $16.84 on May 25 to $13.15 on June 7. The APIL reported that distillate stocks fell by 1.45 million barrels on Tuesday, June 13 while the EIA reported an increase of only 300,000 barrels the next day and the processing spread moved back up above the $14.50 per barrel level.

Over recent months, these processing spreads have been excellent guides for changes in price momentum in the crude oil futures market. Keep an eye on product prices for clues about the path of least resistance for oil. It seems that heating oil cracks may have found a bottom and if gasoline refining spreads do the same, we could see a recovery in the price of oil back towards the $50 per barrel sweet spot in coming sessions.

I continue to believe that crude oil will head back towards its sweet pivot point sooner rather than later. Sentiment in the oil market remains bearish with the recent slide in prices. If history repeats itself, this could be the perfect time to begin buying on any price weakness with $50 and above the target for profits.

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