Applying More Logic To Oil Prices

Adam Feik - Contributor - Energies

I wrote last week about applying some logic to the oil crash, which as of January 20th had taken prices below $27.

It seems like ever since the very day I wrote the article (January 20th), a lot more "logic" has seeped into energy markets, as oil has quickly rebounded to around $34 (I'm sure my article had something to do with that; ha ha).

Could things possibly be stabilizing somewhat?

I know oil prices can always be volatile, but surely the crash that's taken prices from $107 to $27 can't continue forever. So what's next?

At one point in last week's article, I made a not-very-helpful statement that with today's highly sentiment-driven daily price swings, "I wouldn't be surprised to see $15 and/or $45 in the next 30-60 days."

The important question, of course, for long-term investors and indeed, for the economy, is what will oil's new range become, once today's short-term volatility shakes out? What will become the "new normal" range for oil prices, over the next couple years?

Should oil really be in the low $30s? In the 2 months after OPEC's game-changing Thanksgiving 2014 announcement, WTI crude – which had already fallen about 30% from its June 2014 highs of $107, fell an additional 39% – all the way to $45 – by January 28, 2015 (almost exactly 1 year ago).

So in the last 12 months, we've seen $45 (last January), $60 (June), $37 (at year-end) and $27 (less than 2 weeks ago, at the bottom of the recent spike downward). And today the commodity is trading back around $34 again.

Is $30-60 the new range, as energy markets consultant Rusty Braziel believes (as I quoted last week)? Has oil put in its lows, and finally beginning to stabilize?

Or do prices have farther to fall, based on some combination of sentiment, weakening demand, and a global supply system that's ready to pounce on any dead-cat bounce in oil prices by opening up the spigots?

Or (final scenario), will prices come roaring back to a range above $50-60 during 2016, based on having overshot the mark? Not many people expect that; which is precisely the thing that makes $60+ oil worth considering, in my view. Forecasters are most often wrong, keep in mind. Surely the oversupply has been the primary factor in oil's rout from $107 to $27. But based on oversupply alone, is the rout overdone? How much of the last leg down, from around $40-45 to around $27-33, has been driven by traders' souring sentiment alone? Maybe all the panic-selling is over. Maybe the "weak hands" are now finally shaken out. After all, the fundamentals such as oversupply, slowing demand from China, OPEC's pump-baby-pump strategy, etc., have been known for months if not years – and, therefore, must have been "priced in" long ago. So maybe sentiment has simply taken us way too far.

I wrote last week about some of the more "logical"-sounding analysis I'd heard recently. Let's continue in that vein.

Demand Logic

I don't buy that anything surprising has happened on the China front. We've known for years that China's government central planners would begin shifting their economy towards services, that they'd slow down their massive infrastructure build, and that the transition would involve a slowdown in growth. That situation has played out pretty much as expected, with maybe a little extra volatility in Shanghai stocks (which, by the way, are neither a good indicator of China's economic health nor an influential factor in the global economy or markets outside of a few days' worth of market ups and downs.

According to a recent MarketWatch article, China's oil imports grew by 8.8% from 2014 – when measured (properly) in volume terms (barrels, not dollars or yuan). Of course, Chinese oil imports are down in price terms, because oil prices have crashed 70%. According to Fisher Investments, many experts expect Chinese oil demand to continue growing by 6% in 2016 (in terms of volume). Barclays expects only 3% growth. Either way, China continues to consume and continues to fill its strategic reserves. And investors by now surely must have already priced in somewhere between 3-6% volume growth from China.

Demand continues rising. Not at a large pace, but rising nevertheless. Don Luskin, in his January 7th WSJ opinion piece, noted this:

"Oil prices have fallen more than 70% since mid-2014 while demand has been rising. The drop is entirely the result of America's supply-side technology breakthrough with horizontal drilling and hydraulic fracturing—fracking."

I agree. Data shows demand has continued growing in the midst of all this! Remarkably, the principal reason for this crash has been supply.

Price Volatility Logic

Oil prices were falling like a knife until January 20th. On January 16th, in the midst of the freefall, Larry Kudlow hosted John Kilduff, founding partner at Again Capital Partners, on his radio show. Said Kilduff:

"The folks who trade based on what the chart is telling them can only do one thing and that's sell."

That was patently true at the time. Now, of course, depending on how short-term the indicators you use, oil prices may be gaining technical strength thanks to a fantastic 7-day, 25% rebound from $27 to $34. Powerful. But could it be just a head fake?

Let's carry that logical one step further, to say this: Just as all trees don't grow to the sky, oil’s not going to zero. On the other hand, is last week's bounce back up to $34 enough to bring out the shadow inventory that producers have been standing ready to bring online? Already, Friday, Iran said it "won't consider a cut" until its exports have increased by 1.5 million bbl/day (compared to its current level of about 1.1 million. Russia and Saudi Arabia had said last week they're considering production cuts, but Iran's Friday statement makes any coordinated cut appear unlikely. Then there're the fragmented US producers. Predicting their response is impossible, given that there are still so many disparate players in so many unique positions.

Human Behavior Logic

Back to Kudlow's Jan. 16th radio show for some more logic. Kudlow's other guest was Mark Mills, a senior fellow at the Manhattan Institute and a Forbes columnist. Kudlow asked Mills if the well-managed US shale companies can make money on their wells at, say $30 or $35. Mills replied, yes, and added that many of the best can still break even at $20 or even in the high teens. Then Mills said this:

"And the Saudis know this. (The Saudis') marginal wellhead breakeven costs are rising because they're chasing more and more difficult oil in their domain."

Truly, the US shale revolution has given OPEC a run for their money. The Saudis and others still feel compelled to continue pumping to protect market share, even as prices have dropped 75% over the past 19 months.

Watching the behavior of OPEC producers, non-OPEC producers, and North American producers has been a fascinating study – and will continue to be so, because (as Mills said), many shale producers can continue to break even with prices around $20.

Logical Conclusion

All things considered, from my research for these last two articles, I stand by my vanilla-sounding statement that volatility could easily show us both $15 and $45 prices in the near term.

Longer term, if I had to make a bold call, I'd be tempted to go with oil in the $50s or possibly even $60 sometime in 2016 or 2017 – precisely following the logic I laid out earlier in this article (in the 1st section, 2nd-to-last paragraph). In short, I wonder if sentiment has taken prices to extremes that won't last long, now that many of the weak hands have probably been driven away and won’t return for many years.

In my business (managing people's money), I never place too much emphasis on one bold call. So I won't be betting the farm on it. In fact, the reason I never go "all in" on anything is I've learned to always humbly recognize I could be wrong. Markets have a way of humbling you if you don't humble yourself first.

So I ask myself things like: How could I be wrong about oil going back to the $50s within the next 18-24 months? Well, the answer to that is easy. And manifold. Oil could stay in the $30s or below due to persistent oversupply alone. And/or due to a sudden global recession (which doesn't look imminent now, but could happen down the road). And/or due to the fact that perhaps too many people are still too optimistic about oil prices. Remember, a market that has too many bottom-fishers can have a hard time finding that "capitulation" moment. And so on, and so on.

Finally, a few thoughts on a broader topic. The carnage in oil and energy has been dramatic – a fact no one would deny. But here's a couple more points on whether oil and the energy sector's carnage are likely to derail the broader economy and markets.

Turning again to John Kilduff, founding partner, Again Capital Partners, on Kudlow's show:

"It's not a big enough sector to take down the economy. It's not even a big enough junk-bond sector to take down the banks. They're all well reserved and protected against any fallout from bankruptcies or defaults."

Having studied the issue, I have to agree with Kilduff, and I just wanted to pass along that one last, important bit of logic. Next week, we'll dive back into some more specific energy company issues.

Adam Feik Contributor - Energies

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.

6 thoughts on “Applying More Logic To Oil Prices

  1. rally of gold is over or is Non form payroll .what will be happened in gold.

  2. When comparatively very sharp and faster deep already taken place, now consolidation face started, with even possibilities of $ 15 and $ 45 both, as explained above article, so now without taking any guess, either for up or for down trend, one must monitor short term buy sale signals and follow that for short term trades accordingly with very strict Stops, because now further trend will badly damage both Bulls and Bears equally, probably, market will just react against every factors so when traders will try Long, may be there will be deep, and when short, there will be a bounce.

  3. Oil is looking weak on opening. Looks like a trade for the upside later in the day. 1:00 PM EST should prove this out. I will be buying on weakness selling oil on strength. UWTI or UCO could work but may get momentum on the frackers to upside even more.

  4. Dollar is collapsing this morning. Financials will probably go further south and oil should follow through to the upside with a weaker dollar and the Fed tightening song getting louder. The derivatives market and tremendous leverage will be pulling the tail of this beast. Pay close attention to oil volatility index and dollar/Euro and dollar/Yen, the TBT and 10 yr note and VIX. If the 50 day moving averages of the frackers break to the upside watch for follow through momentum. A lot of money will be coming out of dollar denominated assets and the financials probably moving into gold and oil ... maybe copper. FCX may be a great play today as well.
    I think I am starting to like the MPLX LP on severe weakness. Pay close attention to very low RSI and your candlesticks for a trade reversal.

  5. By the way it was your Jan 30th article Diving for Opportunity and your chart pattern that showed me the way through the darkness. I went long oil yesterday and held through the lows. I expected the 29.4 reversal. But it was the collapse of the dollar and the strength of the Yen that was also key for me. The 50 day averages may get penetrated on a number of the frackers if we get follow through tomorrow. The dollar may get crushed again. Of course the Fed will need to tighten... or so the song will go.

  6. Keys - Deflation is still the trend, oil trend is still down, global rates are going down to stimulate economies. The low rates for so long have allowed to many inefficiencies to take root in the current manipulated Central bank controlled economies. Free enterprise needs to return or this tree of knots will continue to bear no fruit. Just think how much oil can come back on the market in a very short time. Saudi Arabia can pump 1 to 2 million more barrels a day if it decided to, America frackers could easily pump that much and more, not to mention the 500 million plus barrels in storage, Iran and Iraq are ratcheted up production {in additon to Iran 50 million barrels in barges and storage ready to go, Russia has more capacity, not to mention Venezuela with 300 billion in proved reserves, China is building up its oil drilling business, India as well, on and on across the globe. The supply lid is in place {Peak oil is a thing of the past}. {Don't forget the new process for oil sands that are using solvents and reusing them to clean oil at $20/barrel and there are hundreds of billions of proven tar sands and oil sands across the globe. There are also companies turning LNG and NG into oil for ~$3-$6-$9/barrel. Then there are all the new green tech innovations, especially the gas disposition of silicon the uses silicon seed crystals to drop out pure silicon from common silicate sand mixtures. This can potentially drop the cost of solar panels down 90%. Cheaper energy is a reality for the masses. However wars and greedy man can change that so the geopolitical risks are about to go through the roof. Oil did a fibonacci retracement today of .618 at ~29.33 today so one should have expected this violent move up of 9.5% how much a leg this will have well I guess that is the question. Pay close attention to the dollar/yen relation ship and the dollar/euro as well as China tonight. If the dollar strengthens
    the move may have been short lived and look for lower oil prices soon and a collapse off the 50 day moving averages of a number of the fracking oil stocks. If dollar collapses and Financials get much weaker look for a break through the 50 day averages for a momentum trade.

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