3 Big Reasons To Be Bearish On Oil For Even Longer

by: Miles White


Oil has fallen substantially from the high of $136 to the low of $28. A rebound to the low $50s is as good as it gets for oil!

Nigeria and Libya cannot afford to cut their output, and do not have to according to the deal they signed with the OPEC.

OPEC does not have enough control over world supply to lower oil prices enough for many of the included countries to fund their government budgets.

There is a stacked social/tech agenda against fossil fuels that investors have continued to ignore despite growing opposition from consumers.

This dip in oil prices is going to keep oil down for an extended period (one year at least). Even BP (NYSE:BP) sees oil at $50 a barrel, meaning even the industry isn't particularly bullish on the subject. However, over the next few months, many investors will preach to buy to "buy the dip" on oil every time it falls...I strongly advise you don't unless you are prepared to invest multiple times to find the final low...Otherwise known as shooting fish in a barrel. Chart 1 shows the falling price of crude oil in 2017. Each dip goes lower and lower without a definite bottom. To make things worse, oil sentiment hit what CNBC defined as an overall low in June 2016:

"This is like a falling knife right now, I genuinely haven't seen sentiment this bad ever," Amrita Sen, the co-founder and chief oil analyst at Energy Aspects, told CNBC on Wednesday. "We have had clients emailing saying they have been trading this for 20 or 30 years and they have never seen something like this," she added.

With the technicals looking bad, companies still recovering from weak oil prices in 2016, and the overall sentiment/outlook looking terrible...the next year for oil looks like bleak.

1. Nigeria and Libya are Ramping Up Output...They Can't Afford Not To

The most recent quest to increase oil prices is to cap supply in Nigeria and Libya. Nigeria is a country that depends on oil, similar to Saudi Arabia and other GCCs (Gulf Coast Countries). In fact, Nigeria's oil dependence is so extreme that its currency, the naira, is actually directly correlated with it. An article from The Business and Management Review stated:

"The exchange rate is about 150 naira to one dollar but when oil price fall the depreciation of the naira resulted to the same 70% or $1 to N250-N300 naira foreign exchange exposure."

Furthermore, the chart below shows Nigeria's oil production and government revenues are correlated as well. When oil prices rise, the government gets comfortable with its revenues. As they fall, government revenues fall.

Source: CIEC

The same article from The Business and Management Review goes on to describe how Nigeria's dependence on oil is apparent to the rest of the world:

"The appearance of dollarization of the economy suggest that foreign currency demand and supply has to meet food imports, medical treatments abroad for the elites, the craving external tourism interest of elites, foreign exchange demand for tuition fees and the general craze for everything foreign is due to inadequate capacity in domestic level of production of commodities."

The other country undergoing possible production cuts is Libya. Libya has a problem similar to Nigeria. We can see from the chart below that Libya ranked 2nd in 2010 (it is difficult to obtain recent data because of the current civil war in Libya that started in 2014). War sustains oil dependence even further because other industries have trouble developing during high instability and low security.

Source: World Economic Forum

Any country that depends so heavily on the domestic production and sale of one commodity will have its entire future dependent on that commodity. Nigeria and Libya cannot and will not slash oil prices. They cannot afford to.

2. OPEC Cannot Cut World Supply Enough to Increase Price Anymore

OPEC is the world's largest and most successful cartel. It can manipulate entire markets to its whim...or so it used to be able to. There is a classical economic methodology that "proved cartels are not economically sound." That doesn't exactly hold true for oil. Cartels can work semi-perfectly as long as they are well controlled and do not depend on other supply factors. When OPEC controlled a much larger share of US oil imports, they could restrict supply and consumers would feel the bite. But recent developments in US oil production, along with the failure of OPEC members to cut supply long term, mean the oversupply of oil is inevitable.

Source: CNN Money

A key problem OPEC faces is it only accounts for 44.1% of global production and only 14.1% of US imported oil. The U.S Oil Imports Shrink Chart shows the growing energy independence of the United States. It is possible for the United States to be energy independent even in a predominately oil heavy economy.

To best understand how domestic oil production was able to increase so quickly, we have to understand production cost differences. Below, the bar graph illustrates how expensive drilling for a barrel of oil is. The United States is currently profitable drilling for shale at $22.50, which means even $40 oil is possible right now.

Source: Wall Street Journal

New refining and drilling technology is responsible for the United States ramping up its production after 2009. Shale oil was once very expensive to refine, and cheap imports displaced domestically produced oil. As shale oil became cheaper to refine, more US gas companies began drilling and cheaper domestic supply flooded the market. Combined with high OPEC supply, the world now has huge inventories of oil, with shrinking demand. Oil prices plummeted until 2016. The low of 2016, shown below, was finally when OPEC decided it was time to discuss production cuts, which were announced in late November 2016.

Source: Nasdaq

To illustrate falling oil prices in a petrostate, I will use Saudi Arabia for a case study. Saudi Arabia makes a good candidate because of the amount of data available, as well as the control it has in OPEC. The bar graph below shows Saudi Arabia's foreign exchange reserves. The government lost 30B SAR in 2016 due to low oil prices. The drop has begun to speed up as well, losing 12.5B SAR in January 2017 alone. Saudi Arabia cannot sustain its current budgets with oil under $50, but its people are accustomed to certain luxuries that are not easily taken. This makes budget cuts difficult and ineffective. For example, in 2015, Saudi Arabia attempted budget cuts to try to deal with the situation, but foreign reserves are still falling as of 2017.

Image result for SAudi arabia falling revenue

Source: Trading Economics

Bringing together the United States shale oil supply and Saudi Arabia's failure to cut supply to the levels needed, we can start to see why the world has a surplus of oil. We can also see why Saudi Arabia's, along with OPEC's, cuts to oil supply are going to fail. As the countries cut their oil supply, they will shrink their government revenues. As a market response, oil will go up in price, which initiates the demand for more suppliers. United States oil drillers begin to drill and produce more crude oil, which brings the price back down. Because OPEC cannot directly control the entire market, specifically the inelastic market, its supply cuts are ineffective.

The double-edged sword for oil is renewables are decreasing in price and increasing in availability. The pie chart below shows renewable energy accounted for 10% of energy produced in the United States. Currently, coal is the number one displaced energy source, but petroleum and natural gas are soon to follow.

Source: Environmental Protection Agency

The growth in shale oil and renewable energy production is enough to partially offset the US dependence on foreign oil. European markets are still dependent on oil from foreign markets, but have done a better job offsetting with renewables rather than domestic oil supply. Domestic oil supply increases in the US and renewable energy growth in Europe has reduced OPEC's control over oil prices and will keep them lower for longer.

3. The 4 Horsemen of the Eventual Apocalypse: Technology, Climate Change, Human Rights, Globalization

The third reason is more of a consolidation of the ankle biters that is going to eventually drive oil back into the ground. Whether or not you agree with any of the topics, the world is formed around you, and opinions mean little to nothing as events develop. We, as investors, have to deal with the future we are presented and invest accordingly.

Technology: The most obvious of the four is technology. Renewables and alternatives are becoming cheaper and more efficient. Nobody sees oil being the force to power the entire world in 2050. That would be like assuming trains would be the main method of transportation forever in 1900.

Downside for Oil: Technology is always disrupting industries, and investors who fail to see which will be displaced, end up getting burned. I don't need to preach this one because it writes itself: technology will kill the oil industry for good eventually.

Climate Change: 97% of scientists are claiming humans are responsible for climate change, and carbon dioxide levels in the air are responsible. Carbon dioxide is a byproduct of using oil or gas for energy. It is also the byproduct of cellular respiration and one of the main reactants in photosynthesis. The world would turn normally, in balance between mammals and plants, but increased levels have created a warming effect that we call Global Warming.

Downside for Oil: This is not a good thing if you are in one of the industries where the finger is pointed at you. The issue of global warming has brought increased scrutiny upon oil companies which has led to regulations on drilling and even talk of a carbon tax. This scrutiny has also translated into tax breaks for renewable energy sources that continue to bring their cost down relative to oil. As climate change builds an even bigger following, there will be more uproar over oil use and production.

Human Rights: Many of the states that produce oil are human rights violators. This is best summarized in "Righteous oil? Human rights, the oil complex, and corporate social responsibility" by MJ Watts at Berkeley. Watts correlates the growth of a petrostate with human rights violations. He summarizes:

"But in the human rights community, it has been the staggering corruption and the appalling lack of transparency associated with the collusions between oil states and the supermajors that emerged as key policy questions in the 1990s. The petrostate became a concern not just for the human rights community but for international diplomacy and global regulatory agencies (66). Karl (64) and others have shown how oil tends to promote patronage and rent seeking rather than statecraft, transparency, and state-institutional capacity. But it is the rank corruption, fraud, embezzlement, and outright pillage of the public purse that strikes to the core of the rights violations perpetrated by states and companies."

Downside for Oil: The United States, along with other European nations, tries to take a harsh stance when dealing with countries that have poor human rights records. However, for a long time, countries exporting oil were somewhat exempt from this because they provided a highly demanded commodity. Here's the report on Saudi Arabia, for example. But from what I have illustrated above, the US and Europe are decreasing their dependence on foreign oil and now have little incentive to trade with nations committing human rights violations.

The real kicker here is consumers have associated poor human rights records with countries that produce oil already. They know the poor human rights records in Venezuela, Nigeria, Saudi Arabia, Iran, Russia, and even Kuwait. As the human rights argument against these countries gains traction, and the price of renewables decreases, consumers will switch to renewables. A moral argument is hard to compete when two goods are the same price.

Globalization: Globalization has been an overall positive for oil producers. The rise of free market theory during the 1980s ended long imposed US tariffs on foreign oil. It drove the price down in the US and allowed oil from the Middle East to flood the market. This is an ideal situation according to classical economics. Middle Eastern countries could focus on producing as much oil as possible, and the United States could focus its efforts on services and defense. It was a great partnership until OPEC decided it could raise profit margins even more. Now highly dependent on foreign oil, the US would have to play a part in politics as well as succumb to higher prices.

Downside for Oil: Those events all transpired 30-40 years ago. Today, globalization is much more than the exchange of goods over wider markets...it is the shrinking of the world along with the barriers that once existed. This facilitates the spread of ideas, theories, technologies, etc. A lot of this was made possible in 1995 with the creation of the World Wide Web. The Internet has made information more accessible than ever. It too has a role to play in the end of oil for the following reasons:

1. The Internet promotes free speech and press, the ultimate nightmare for a petrostate that depends on suppressing its people. Look at the Arab Spring in 2011, which was the first widespread revolutionary movement in the digital age.

2. The Internet increases the rate of research and development. 30% of the budget the US allocated for research was in alternative energies.

3. It informs consumers, which leads to faster behavioral changes.

Globalization and the Internet are another issue standing in the way of both oil producers and oil investors. Oil states may be less reliable in the future, and renewables/alternatives will replace the void created. Consumers are picky, impatient, and demanding. Producers and investors simply have to put up with it.

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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