Oil: Slippery Road Ahead

Includes: OIH, USO
by: Gold Digger

On Wednesday, a Goldman Sachs analyst came out again to say that oil is headed for $149 by the year-end. Looks like Goldman has made big bets on rising oil prices, and of course, this analyst may just trying to turn that position into profit.

But I wonder if this analyst really knows how the fundamentals of analytics work. Goldman is again harping on the supply-demand equation, while we have seen clear indications that demand for oil is highly elastic. People will cut back their oil consumption (the biggest consumer, of course, is the US, where individual consumers are the primary oil consumers) if oil prices try to rise further.

Most financial models are highly unrelated to real life, and most of them fail in real life situations. If that is not the case, computer programmers and analysts would be the richest people in this world. So in the model world, demand of oil will remain static or will keep rising; but in the real world, just the opposite is true. Especially since higher oil prices will help in finding alternative energy sources.

Now this almost sounds cliche' and most people don't want to believe that we are close to any breakthrough there, but we already have at least 10 car models lined up for release before 2010 which have gas mileage of more than 50mpg. Assuming current average mileage for vehicles is 20mpg, this mileage efficiency equates to almost a 50% reduction in consumer demand of oil in 2010 and beyond. But investors will see the oil prices going down much before, as the real demand tapers off.

This week's US oil inventory data including the follow stats: US crude oil stockpiles rose almost 9.4 million barrels while gasoline inventories declined by almost 6.2 million barrels. What do these figures tell me? One, crude oil demand declined significantly this week. This implies refiners have enough crude already for the demand that they anticipate in the coming weeks. Second, gasoline stockpiles declined because consumer who saw gas prices decline by almost 50 cents within two weeks filled their tanks for a "just-in-case" scenario. Does that mean "real" demand for gasoline went up so much this week? Absolutely not. I once again emphasize the word: "real".

But unfortunately, Goldman's demand-supply models don't differentiate in real and artificial demand. Or simply put, models do not have intelligence. They simply rely on data, and data can be very skewed for multiple reasons. My sympathies are with Goldman if they are long oil.

For the investors, my advice is to avoid trading in oil. But if you absolutely have to, then short every uptick in oil prices. In my opinion, at current levels any price of oil to the north of $120 is a good shorting opportunity. Oil will be trading below $90 in next six months. Investors who have bought ETFs like United States Oil Fund LP (NYSEARCA:USO) should book their profits and close their open positions. Unfortunately, people who bought USO when oil hit $147/bbl will have to close their positions at a loss. But it's better to minimize the loss by closing the positions now.

Another factor that will contribute to oil's fall is the rising dollar. No matter how skeptical we grow of the US economy, the tight correlation between the US economy and rest of the world's economies means that the US dollar will be gaining further; if the situation gets bad here, then it will be worse in the rest of the world. We can see this tight correlation religiously reflected in the stock markets of the world. If the Dow and S&P go down, the next day sees Asia to Europe decline. If the stock market here goes up, the next day other stock markets rise, too. The dollar has still more room to rise further. And that will take the road for oil even more slippery.

For the Oil Service HOLDRs ETF (NYSEARCA:OIH), fundamentals remain strong, but again, it's highly correlated to oil prices, so it might be going down with it. However, I would suggest buying OIH if it goes down below $165 (its support area). But once again, buying OIH does not mean you should buy oil or USO. USO in particular is headed towards $80 from its current level of $93.

For traders, the volatility in oil prices will still be very high and they will have a good opportunity to utilize it to their advantage, as long as they keep in mind that the graph for oil is heading downward, barring a 1-2 day price rise here and there.

Disclosure: I don't have any positions in USO, OIH. And I am neither long nor short oil, if you excuse 15 gallons in my car as not being long oil/gasoline. But I plan to short USO if it goes above $96 mark.