Monday, January 26, 2015

Will the Crude Oil Prices Move-up in the Short Term: Fundamental and Chartical (Technical) Views
The American consumer got a surprise gift this holiday season: the dramatic collapse in the price of oil. The Crude Oil prices have nosedived in the past few months. The spot price of Brent crude reached $115 a barrel in June, 2014 and was above $100 a barrel as recently as September. Since then, it plunged from north of $100 a barrel to less than half that level now (< $50 a barrel). 
Oil prices have been, the victim of a growing surplus brought on by booming U.S. production and weaker-than-expected demand. As prices have careened toward six-year lows, the market has become more volatile. That has given investors opportunities to score big profits by betting on further declines--some traders say the market has fallen too far, too fast—creating the potential for an equally sharp rebound.
The trend has sent US gas prices down to a national average of under $2.20 per gallon, with rates under $2 per gallon in some states.

The benefits of cheap gas are widespread, though the price declines are more of a mixed bag for economies in U.S. states with large energy sectors.

The collapse of crude oil over the last year is one of the biggest asset crashes since the Great Recession and therefore, where there’s crisis, there’s often opportunity.
Many money managers are staying on the sidelines, searching for clues that could mark a turning point for the market. These can range from economic growth forecasts for major oil consumers such as China, to retail gasoline prices and auto sales in the U.S., which could drive future demand. Lately, the market has become particularly focused on a survey of drilling rigs operating in the U.S. that is released each Friday by oil-field-services company Baker Hughes Inc., which can be an early indicator of how quickly production will grow in the future. The number of oil rigs operating in the U.S. has fallen for six weeks in a row.

From a historical perspective, this collapse ranks a bit smaller than the crash in 2008. During that period, crude dropped from $140 per barrel to $40. While the current drop from $108 per barrel during the June 2014 peak to $46 is significantly smaller, that they’re comparable at all is staggering.

Now, there is a sharp divide among energy experts regarding the future direction of crude oil prices. The Saudi Prince Alwaleed bin Talal recently stated that oil prices could keep falling for quite sometime and $100 a barrel will never come back. Earlier this month, investment bank Goldman Sachs weighed in by slashing its short-term oil price target from $80 a barrel all the way to $42 a barrel. 

However, don't get to pessimistic, there are still plenty of optimists like billionaire T. Boone Pickens, who has argued that oil will bounce back to $100 a barrel within 12 months-18 months. Pickens thinks that Saudi Arabia will eventually give in and cut production. 
Though, this may be wishful thinking, supply and demand equations point to more lean times ahead for oil producers. 

Now to understand this phenomenon, from a different standpoint, let us look at the few charts below. 
Crude oil indicated that a possible major top was in place back in August 2014 when prices broke below a two-year trend line, signaling a change in long-term trend.   This is shown in the above chart when the price of WTIC Light Crude Oil fell below $95 / bbl.
In recent weeks, the decline in crude oil has entered the target zone of the four-year symmetrical triangle top completed in October which is around $44/bbl.  Any bounce back might face stiff resistance after several support levels were broken.
From 2011 to mid-2014 and including a brief period in 2008, oil prices were at historically high levels, higher than where it was during the period 1979 to 1983 when the Iranian revolution and the Iran-Iraq war disrupted oil supplies. And that’s after adjusting for inflation. 
We have seen from the above, that Chartically speaking, the crude oil prices looks negative in the short term.  Now let us look at some of the pros and cons of this episode. 
  • International Energy Agency (IEA) currently projects that supply will outstrip demand by more than 1 million barrels per day, or bpd, this quarter, and by nearly 1.5 million bpd in Q2 before falling in line with demand in the second half of the year, when oil demand is seasonally stronger.
    That said, these projections are built on the assumption that OPEC production will total 30 million bpd: its official quota. However, OPEC production was 480,000 bpd above the quota in December. At that rate, the supply-and-demand gap could reach nearly 2 million bpd in Q2.
    Theoretically, this gap between supply and demand could be closed either through reduced supply or increased demand. However, at the moment economic growth is slowing across much of the world. For oil demand to grow significantly, global GDP growth will have to speed up.
    On the flip side, after QE in Europe, there are talks of boosting of the economies of the EU. Also, India is coming up strongly, with the current stable government in place.
    Hence, we cannot take the argument of "Supply Outstripping Demand in Future" on the face value. Moreover, any supply cut either from the US or from the OPEC, could push     oil prices to rebound in the next two-three quarters.
  • Now, there are two ways that global oil production can be reduced. One possibility is that OPEC will cut production to prop up oil prices. The other possibility is that supply will fall into line with demand through market forces, with lower oil prices driving reduced drilling activity in high-cost areas, leading to lower production.
    OPEC is a wild card. A few individuals effectively control OPEC's production activity, particularly because Saudi Arabia has historically borne the brunt of OPEC production cuts. Right now, the OPEC bosses have opined to let market forces work. The moot point is: will Saudi Arabia cut production? In the 1980s, when a surge in oil prices drove a similar uptick in non-OPEC drilling and a decline in oil consumption, Saudi Arabia tried to prop up oil prices. The results were disastrous. Saudi Arabia cut its production from more than 10 million bpd in 1980 to less than 2.5 million bpd by 1985 and still couldn't keep prices up. But having said, this time the there are chances that other countries in OPEC could try to chip in with their own production cuts to take the burden off Saudi Arabia. However, the other members of OPEC have historically been unreliable when it comes to following production quotas. It's unlikely that they would be more successful today. The problem is that these countries face a "prisoner's dilemma" situation. Collectively, it might be in their interest to cut production. But each individual country is better off cheating on the agreement in order to sell more oil at the prevailing price, no matter what the other countries do. With no good enforcement mechanisms, these agreements regularly break down. But then any past track record cannot be future almanac. Isn't it? Therefore, we cannot totally rule out production cuts by the OPEC, if the Crude Oil continues to trend low.
  • Another interesting point which needs to looked at is that during the week ending Jan. 9, U.S. oil production hit a new multi-decade high of 9.19 million bpd. Surprisingly, in the last June -- when the price of crude was more than twice as high -- U.S. oil production was less than 8.5 million bpd. Any clues, about this outlandish US stance?
Conclusion: We have seen from the chart above, that at the present moment the crude oil looks bearish, but this could change, with change of stance, either from the US or from the OPEC. Meanwhile, the demand could pick up from China, India, Japan and other major oil consuming nations. 

In the long run -- barring an unexpected intervention by OPEC -- oil prices will stabilize around the marginal long-run cost of production (including the cost of capital spending). This level is almost certainly higher than the current price, but well below the $100 a barrel levelthat's been common since 2011. India, China and US would be happy if the crude oil price stays lower than $80 per barrel. 

West Texas Intermediate oil prices fell sharply on Friday, as concerns over slowing demand and ample supplies combined with a rally in the dollar weighed. 

To add salt to the wound, (i) the U.S. Energy Information Administration said Thursday that U.S. crude oil inventories rose by 10.1 million barrels last week, the biggest weekly gain since March 2001 (ii) the U.S. dollar index, which measures the greenback’s strength against a trade-weighted basket of six major currencies, rose to more than 11-year highs of 95.77 on Friday, before trimming gains to end at 95.32, up 0.69% for the day and 2.33% higher for the week. A stronger U.S. dollar usually weighs on oil, as it makes dollar-priced commodities more expensive for holders of other currencies. (iii) the euro fell to fresh 11-year lows against the greenback after the European Central Bank unveiled a €1.2 trillion asset purchase program on Thursday. The central bank will purchase €60 billion in assets per month, starting in March and continuing until late 2016, to combat slowing growth and inflation in the euro area. Now, we need to asses future Chinese demands, the world's second largest oil consumer after the U.S. and has been the engine of strengthening demand. Indian economy is also improving, which will fuel energy demand. 

Now let us summarize, why the Crude Oil price fell nearly 60% since June: 
(i) Apprehensions that the World Growth will slow down--which had a sentimental effect in the Crude Future Market. 
(ii) The Organization of Petroleum Exporting Countries resisted calls to cut output, 
(iii) The U.S. pumped at the fastest pace in more than three decades, creating a glut in global supplies. 
(iv) The U.S. dollar index, rose to more than 11-year highs of 95.77 on Friday, before trimming gains to end at 95.32, up 0.69% for the day and 2.33% higher for the week.

If there are positive changes change in any of the above four points especially from the U.S. whose inventories of oil and refined products have been rising by about 10 million barrels a week recently, we could see a rebound of the Crude Oil prices. The global supply demand balance can also improve from Q3, though it could worsen again in the first half of 2016 due to the typical seasonal drop in demand. 

Last month, the IEA found that U.S. petroleum storage capacity was only 60% full, but commercial crude oil inventory was at 75% of storage capacity. This percentage could rise quickly when refiners begin to cut output in Q2 for the seasonal switch to summer gasoline blends. Traders have even begun booking supertankers as floating oil storage facilities, aiming to buy crude on the cheap today and sell it at a higher price this summer or next year. If oil storage capacity becomes scarce later this year, oil prices will have to fall even further so that some existing oil fields become cash flow negative. This makes the case for slowing the supply vector. 

At today's prices, oil investment will not be sufficient to keep output up in 2016. Thus, T. Boone Pickens is probably right that oil prices will recover in the next 12 months-18 months, even if his prediction of $100 oil is too aggressive. With an increase in storage capacity, the price of crude oil could improve. 

And the big news over the weekend was the landslide victory for radical left wing party Syriza in Greece's parliamentary elections. Syriza ran on a platform of rejecting the austerity measures imposed on Greece by the Troika following the eurozone crisis in 2010. This could change the dynamics in Europe. Also, an improvement in sentiment due to stimulus by the European Central Bank over the coming days could fuel positive bets, on the Crude Oil futures; though the bearish overhang on crude remains with supply exceeding demand. And yes, crude at $60 per barrel by the year-end does not look too steep a target. 

However, the problem will rise if OPEC, US and other major oil exporting countries continues to maintain that Oil Output Must Rise to Compensate for Price Drop. 

It is to be understood that these countries, lost about 50 percent of their revenues because of the slump in oil. Oil slid more than 50 percent since June as the U.S. pumped at the fastest pace in more than three decades and the Organization of Petroleum Exporting Countries maintained its daily production target of 30 million barrels, resisting calls to makes cuts to reduce a supply glut. 

But this cannot continue for long, as many Oilfield services companies, which handle the rigs for exploration and production are scaling back their work forces. Schlumberger, the largest oilfield service company, said last week it would lay off 9,000 employees. 

“The time has come for a meeting, possibly a summit meeting, for all producers, OPEC and non-OPEC,” to discuss ways to lift oil prices, Ayad Allawi, a Vice President of Iraq, said in an interview. “Next year we will start seeing prices rising, it will level off between $60 and $70. This year it will remain between $40 and $50. 

One of the biggest lessons from the financial-market crash half a decade ago was ignoring panic and instead scooping up good assets at fire-sale prices. Would that lesson apply to oil today?

The first thing to consider is whether there’s any reason prices will recover at all. What are the fundamentals? Unlike corporations, oil as a commodity can’t really go bankrupt. Oil is a necessity, demand is relatively inelastic, and it dominates in practically everything that requires energy. It’ll always be needed over the immediate time frame. While the price may not hit $100 again in the short term, there is a fundamental limit to how low it can go.

At a bare minimum, oil should always cost what it takes to pump it out. According to 2008 estimates from the International Energy Agency, that value varies considerably depending on location and efficiency. Middle Eastern oil has been estimated to cost approximately $6-$10 per barrel due to the large economy of scale and the relatively mild near-surface conditions. Though these locations have very low costs, they don’t have sufficient capacity by themselves to satiate demand. For other onshore pumping, costs can be around $6-$39, and for deep-water offshore wells, costs can reach $32-$65 or more.

More difficult sources such as oil sands were estimated at around $30-$70 and shale oil wells were estimated at $50-$100. Since the cause of oil’s current crash is rooted in Saudi Arabia’s goal to push shale oil out of business while leaving conventional drilling profitable, there’s a potential bottom of $30-50 per barrel — close to today’s prices. While nobody except Saudi Arabia knows for sure, there’s a high chance prices will be allowed to rise once the goal of squeezing shale is complete.

Second consideration: How long would it take to profit from such an investment? History doesn't have a clear answer on this as the 1980s oil crash took decades to recover. However the 2009 oil crash only took 2 years, much faster than the stock market recovery. If Saudi Arabia’s goal is to push shale out, taking into account how long hedges last for, how long companies can operate in the red, and how fast they can slim down, one to three years may be reasonable.

Lastly, the most important question: How to profit from this? For the average retail investor, this is trickier than at first glance. The most obvious ways are betting on the crude-oil commodity price itself, betting on energy-sector companies and betting on oil-producing countries. 

Besides, a report by the International Energy Agency (IEA), said there were signs lower prices had begun to curb production in some areas, including North America. So, at the moment it is anybody's game in the Crude Market; but I feel the Crude Oil prices have more or less bottomed out at the current moment. A slow rise is in the offing in this week.

Sources: 
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