Sorry for the late post, the stock market dip this morning delayed my writing. Today’s article is about crude oil. In the context of today’s equity rout, this is going to seem pretty tame, but I think the lessons learned from the recent oil mini-crash are instructive about the nature of today’s macro picture. I thought you guys might need something to take your minds off the wicked volatility this morning.
Apart from the swoon in the equity markets, the next biggest story on everyone’s lips is the complete annihilation of crude oil prices. Since peaking at $105 this summer, the price of crude oil has plunged to just over $80.
There are lots of reasons for the drop in price, but there is one big one that most investors are missing.
First let’s review the obvious ones. Global growth has plunged.
It is tough for crude oil to rally when the world economy is coming to a grinding halt.
The US dollar has also experienced one of the biggest rallies in decades.
As the dollar has rallied, crude oil has declined in lock step.
Going into the summer, the large speculators (aka hedge funds) held record net long positions.
The amount of net long positions held by speculators was off the charts. It has since plummeted, but that most likely reflects the puking out of these positions during the last couple of months of declines.
So let’s summarize. Since this summer; expectations of global growth have collapsed, the US dollar has exploded upwards and we had a record long speculative crude oil position. These are the perfect ingredients for a big sell off in crude.
But the real kicker that sent it over the price of oil careening over the edge was something that is not talked about as much.
It has been a while since the markets have focused on the Ukraine Russia conflict. Although it might have disappeared off the front page of the Wall Street Journal, it has by no means gone away. The US administration has instead chosen to fight this war in the financial arena instead of on the battle field. Sanctions against Russia continue to be slowly tightened. Bit by bit, the US and its allies are tightening the noose around the Russian economy. You can see the effect with the dramatic fall in the value of the Russian Ruble over the past six months.
But the real coup de grace is the deal that the Americans reached with Saudi Arabia. I am sure that Obama convinced the Saudis to turn on the oil tap full blast and send the price lower. A lower oil price hurts Russia and has the added benefit of hurting some Middle Eastern countries that share no love for America or Saudi Arabia. It was the perfect weapon to unleash on the world.
Saudi Arabia is aggressively pushing prices lower. From the WSJ:
Days after slashing prices in Asia, Saudi Arabia is now making an aggressive push in the European oil market, traders say.
The kingdom is taking the unusual step of asking buyers to commit to maximum shipments if they want to get its crude.
“The Saudi push is not just in Asia. It’s a global phenomenon,” one oil trader said. “They are using very aggressive tactics” in Europe too, the trader added.
This month, state-owned Saudi Aramco stunned the rest of the Organization of the petroleum Exporting Countries by slashing its November prices to defend its market share in Asia’s growing market. The move, setting a price war in the oil-production group, was combined with a boost in the kingdom’s output in September.
But Riyadh is also moving to protect its sales to Europe, a declining market where it is facing rivalry from returning Libyan production.
After cutting its November prices there, Saudi Aramco is also asking refiners to commit to full, fixed deliveries in talks to renew contracts for next year, the traders say. They say the Saudi oil company had previously offered a formula allowing flexibility of more or less 10% of contracted volumes, the most commonly used in the industry.
“They are threatening buyers” to discontinue sales if they don’t agree with the fixed deliveries, another trader said.
The Saudi selling has created a crash in the price of crude oil. It is made worse by the fact that we have had all of this new shale US supply brought on line over the last decade. The cost of production for this new supply is now dangerously close to the current price.
All these new “miracle” shale companies are suddenly faced with an oil price that is at their cost of production. And the really big problem is that these companies have taken on a staggering amount of debt.
The market always seems to go to the point where it hurts the most people, so in hindsight we should have known that the shale companies would eventually over expand to the point where it wasn’t profitable for anyone.
I have been meaning to write this up for a while, but I have wondered about the possibility that the whole shale oil phenomenon was a massive bubble. I have long held the belief that bubbles are rarely identified by the general investing public, so I am skeptical about the many bubbles that have been forecasted in the last decade. The truly big bubbles, the ones that really hurt, have very few oracles proclaiming that it will end in tears. If you think about the shale oil “miracle,” it is almost universally lauded as a wonderful investment opportunity. The money that has flowed into the shale regions has been mind blowing. But for some time now, smart energy investors have been quietly complaining that the boom has created an environment that will be very difficult for oil companies to make money.
I don’t have nearly the amount of time today to give this the space it deserves. The main point I would like to make is that oil has has gotten crushed by too much speculation combined with an aggressive Saudi/American policy that is using the price of oil as a financial weapon. This has steam rolled on itself and taken oil down to the break even cost of one of the biggest sources of new supply.
Tomorrow I will talk more about the shape of the oil curve. In the mean time, we are probably at the point where you can be buying oil. Yes, it might go down from here, but below $80, the supply response is going to be massive. Also, more than likely, Saudi Arabia misjudged the ferocity of the down move and will let it breathe.
I still don’t have time to update my positions. I had been short, but did not play it well at all. The bulls shook me off too many times.
Yesterday I said that the time to bring in the last of my shorts was upon us, and that if the big one happened, it would happen without me.
So of course the Market Gods made the biggest down day of this whole move happen today when I was flat.
I am starting to buy some selective names. I am dipping my toe in gingerly.