- The oil sell-off was extremely overdone and anticipated scenarios that are very unlikely to occur.
- Saudi Arabia's power to control prices intermediate term is vastly underappreciated by shale struck traders.
- Canada cutting oil exports to the U.S. is one part smart for them and one part "Trudeau's Revenge!"
- Oil inventories have been showing draws and those draws will increase dramatically in January and continue thru about July.
- See the 2016-17 oil charts for clues as to what is coming in 2019.
- This idea was discussed in more depth with members of my private investing community, Margin of Safety Investing. Start your free trial today »
In early 2016, on MarketWatch, I suggested oil was near its bottoms after the OPEC induced oil supply glut. I also said that oil would rally back to the $80-100 per barrel range within a couple years.
My thesis was simple. Investment in long-term slow cycle oil production, such as deepwater and oil sands, had been permanently impaired. This would lead to a "peak oil plateau" that would see oil demand and supply roughly in balance from about now until EVs started to impact oil demand.
By October of 2017, we could see oil's technical path to $80 per barrel.
By April of 2018 we saw oil at the doorstep of $80 per barrel.
WTI oil traded in the upper $60s to middle $70s from May 2018 through October 2018. It hit its high price for the year at $76.40 per barrel. Brent crude peaked at $86.07 on October 4th.
The path of WTI crude oil followed a steady rise from its bottom in early 2016 until the recent correction.
You can see that the price of WTI crude oil has gravitated towards about $80 per barrel so far this century. It is likely to embark on an emphatic price rise towards $80 per barrel in the first half of 2018.
The Trump Double Cross And The Oil Correction
The recent precipitous drop in the price of oil was not caused by the rise in U.S. oil production. Rather, it was caused by a surge in "ROPEC" oil production that was ramped up to counter the Iran sanctions.
With more and bigger waivers for Iran oil granted by the Trump Administration than anticipated, Saudi Arabia and Russia were caught flat footed as their production reached record levels. Since "ROPEC" unwound production cuts in June, their oil exports also ramped up.
As you can see in the first chart, once the waivers were announced for the Iran oil sanctions, the price of oil plummeted in November and December.
Money Flows Matter
It wasn't just ROPEC increasing production to offset waivers to drive down the price of oil. At the same time, shale did in fact hit a new higher level of production of 11.4mbd.
What also occurred was a lack of investment into risk assets. As I covered in 4 Pieces Of Missing Money Crushing Markets, money flows were in distribution in Q4. A lack of investment money available to the markets temporarily depressed the prices of most risk assets, including oil.
So, there was a perfect storm of peaking shale production, peaking ROPEC production, an end of summer demand and a lack of investment capital, which drove oil prices from 2-year highs in October down by about 40%.
Saudi Arabia And Russia's Oil Response
ROPEC announced over a month ago now that they would be cutting oil production by 1.2mbd. U.S. oil futures have been rising since Christmas as the effects are just starting to be understood. There is still ambivalence in the market though, as there are demand fears (more on that below).
More recently, Saudi Arabia has moved very aggressively to also cut exports to the U.S. and other key markets. It is a tactic that has worked in the past to raise oil prices.
The impact of the Saudi cuts of exports to the U.S. cannot really be understated. Saudi Arabia owns the largest refinery in America at Port Arthur. It needs about 300,000 barrels per day to operate efficiently.
As HFIR covered a few weeks ago, Saudi Crude Exports To The U.S. Will Be Shocking Especially For PADD 3. Why is that? Take a look at the map below.
Port Arthur is in PADD 3. As HFIR describes, that is where the inventory build has been. Somewhere between slim and none is the amount of oil that Saudi Arabia is shipping to PADD 3 now. That means that Saudi Arabia will be using its inventory for Port Arthur refining. That action alone could amount to a draw-down of about 9 million barrels of U.S. oil inventory per month.
If Saudi Arabia ultimately cuts exports of oil to the U.S. to the lows of the decade seen in October 2017, then we should expect a similar price move for oil.
U.S. Imports from Saudi Arabia of Crude Oil and Petroleum Products (Thousand Barrels per Day) EIA data
Russia's impact on the U.S. won't be felt directly. Rather, as Russia reduces capex, their production will drift down a bit over time. That will impact marginal oil pricing globally. Russia is a bit of a free rider here, but they are at least contributing to oil no longer falling in price.
In the U.S. inventories are likely to fall back to the 5-year average by spring and possibly lower over the summer.
There is another shoe dropping in addition to Saudi Arabia's cuts. Canada announced it would cut production of oil to America by 325,000 barrels per day. They have in fact gone ahead and implemented that plan.
Canadian inventories would be expected to drop by about 9 million barrels per month. While this does not have as direct an impact on WTI oil prices, it does reduce overall North American and global inventories.
To date, we have already seen the WTI to Canadian crude spread dramatically narrow by nearly $20 per barrel. At the same time, WTI oil has rebounded from its recent crash bottom.
Shale Production Will Be Flat H1
While many would suggest U.S. shale can fill the void, the truth is different.
The U.S. refinery system is heavily tilted towards heavy sour (Canadian) and medium crude (Saudi). The fact that the shale industry is producing record amounts is important for exports, but not for domestic production of distillates, we've had enough light sweet crude for our own use about a year now.
According to the EIA STEO U.S. shale is likely to stall anyway in the first half of 2019. That will remove marginal barrels from the global pricing mechanism.
The stall out is due to the well covered lack of pipelines in the Permian which won't be remedied until the second half of 2019.
Also, we have recently had confirmed that existing shale wells are not producingat the levels projected a few years back when oil companies were going to banks looking for money and selling shares.
Finally, because financing is becoming more expensive and scarce, only companies that can finance production out of cash flow are likely to move the needle on U.S. production. This has been confirmed by recent announcements.
That all adds up to U.S. oil production not increasing until pipeline capacity increases and oil prices rise.
Oil Demand Is Still Rising
Let's discuss the fact the oil demand is still rising. Consider this chart from the EIA STEO:
The IEA (International Energy Association) has reduced their 2019 oil demand growth to 1.3mbd down twice from the original 1.7mbd.
Consider that we might (probably) have seen the worst case factored into the recent oil price correction. What if the worst case doesn't happen?
A trader's retort could be, but China means the worst case might be even worse than supposed. I guess that's true. China did just report a bit of a slump in import-export data. That is significant. If the China-U.S. trade war causes a second half recession we could see oil prices fall off a cliff again or at least test the bottom.
I believe that China is the one wildcard in oil. China demand has been projected to rise again in 2019, though not as significantly as the 15% year-over-year from 2017 to 2018. Much of the Chinese demand should be attributed inventory build there. Also, we know they are making a rapid shift towards electric buses and small delivery vehicles.
There are two reasons China demand surprises to the upside given recent pessimism. First, China is starting to stimulate its economy. They have committed to tax cuts, easier monetary policy and more domestic consumption initiatives.
Further, it appears to be in both President Xi and President Trump's best interest to enter into some kind of a trade deal, even if it is a little more than Xi wants and a little less than Trump wants. As I said way back last February, I think we should Expect Positive Surprises On President Trump's Trade Policies.
Again, we have to consider that a recession could happen if there is no trade deal, as well as, if the Fed isn't as flexible as recently stated. I think both are a long shot, but we must allow ourselves to adjust if that is the case.
Presuming a trade deal and the market believes the Fed is at least on pause for interest rate hikes, if not watch to reduce quantitative easing, then we could see a monster oil rally once inventory starts to shrink on reduced U.S. imports.
Traders Talk Their Book
In what is practically a time honored tradition on Wall Street, as well as, now online and on TV, traders talk their book. They discuss fundamentals and engage in story time with narratives that they often neither believe, nor understand. All they frequently understand is that their jibber jabber could be pushing prices a bit in the direction they are positioned for at the time.
With regards to the narratives surrounding oil right now, and many other trending asset prices, the narratives are wrong. As I discussed above, money flow and President Trump convincing ROPEC to increase oil production into midterms were the main factors that allowed oil prices to get crushed.
The prevailing oil narrative is that U.S. shale oil production coupled with slowing demand growth is causing a glut in global oil. That is wrong. And the story is designed to manipulate you. Shale is important, but it is not the game changer people think it is.
As far as demand, while the IEA has dialed back expectations for increased oil demand in 2019, as we talked about, there is still increasing demand. The combination of rising oil demand, the potential for increased demand on a China trade deal, less spare capacity globally, shale underperforming projections means there is no oil glut and there is unlikely to ever be until when? Until EVs take hold of new car sales.
That all said, I acknowledge that in a previous article, I was a bit early in believing that an oil price reversal was imminent. I did not perfectly project the perfect storm which was occurring in real time.
For newer readers, I would also note that I called the shale boom and the shale crash. I believe that the perfect storm for crushing oil prices is going to be met with a counter-storm come early January. For that, you will want to have an overweight position in oil and certain oil stocks.
Am I talking my book? You decide. Below is a recent free weekly webinar I do each Friday (archived on YouTube), the oil discussion is at about 42 minutes:
Investment Ideas For Oil
I have deliberately ignored the geopolitical risks for oil in this article. Those risks, which I will cover again soon, are not required for oil to rise to around $80 per barrel. If any of those risk materialize, then we are talking about a much higher price tag.
In the meantime, as oil rises in price during the first half of this year, there will be some very good trading opportunities. Buying the U.S. Oil Fund (USO) ETF is a relatively easy trade as oil moves from contango towards backwardation again. A rise from about $50 to about $75 per barrel will give you a 50% gain on USO within a relatively short time frame.
Most larger U.S. fracking companies are well positioned for this rise in oil prices. As a caveat I point out that not all frackers are worth investing in due to poor balance sheets and second tier assets. Picking companies can be very profitable and I will discuss some of those soon.
For now, asset allocators should be looking at a pair of ETFs that are built well and offer liquidity. The VanEck Vectors Unconventional Oil & Gas ETF (FRAK) has the best portfolio among oil ETFs in my opinion. It's top two holdings are Occidental Petroleum (OXY), which I've written about before as being an excellent substitute holding for Exxon (XOM) and Chevron (CVX), and EOG Resources (EOG) which has the lowest extraction costs in the industry.
The SPDR S&P Oil & Gas E&P ETF (XOP) is far more liquid than FRAK and has a more level non-market cap weighted portfolio. Jeff Gundlach has discussed this ETF as a top idea. XOP also has a robust options market.
We rate the U.S. Oil Fund (USO) ETF a buy.
We rate the VanEck Vectors Unconventional Oil & Gas ETF (FRAK) a buy.
We rate the SPDR S&P Oil & Gas E&P ETF (XOP) a buy.
Subscribes to Margin of Safety Investments have received options trades for both as well.
Margin of Safety Investors also received option trades for their oil strategy. To learn more about us, take a free trial. Our New Year's promotion is still running and you can receive your first year for 20% off the regular rate.
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Analyst’s Disclosure: I am/we are long FRAK, XOP, USO. 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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