Crude oil prices have dropped more than 25% since their June peak. So recently, I posed the question whether oil (and oil) stocks still had more overreaction left in them. At the time, oil was testing support at $80.
Since then, oil has been trading in the high-$70s, with WTI crude futures contracts forecasting sub-$80 oil well-into 2016.
The reasons for the continued drop are many: lower demand, rising supplies, a Goldman Sachs (GS) forecast for $75 oil, OPEC and Saudi Arabia not supporting prices. The strong U.S. dollar also means lower energy costs.
That’s good news for consumers, but certainly frustrating not only for investors, but for countries that depend on the money they make from crude oil exports to keep their countries running.
Right now while we’re waiting for energy prices to bottom, let’s take a closer look at some of the headwinds that oil and natural gas are facing … and why the headlines might mislead you out of investing opportunities when the time is right to come back from the sidelines.
Headwind No. 1: Global Oil Demand
The IEA recently reduced its forecast of global oil demand for 2014 by 0.2 million barrels per day to 92.4 million barrels of oil equivalent per day (mboe/d) on lower expectations of weaker global economic growth.
So, demand dropped about 0.02% per day. This does not warrant a drop of 30% in price.
Also, demand has grown every year since 2009 including 2014.
Headwind No. 2: Global Oil Supplies
Let’s look at the other headline that oil supplies are “surging.”
There is higher oil global output from the U.S. and a few members of OPEC — but not all. Oil production as of September was 93.8 mboe/day.
But while there is more supply than demand, that figure is only about 2%. This also does not justify a 30% decline in prices.
Plus, this surplus could easily go away due to oil supply disruptions from Russia or the Middle East due to the war against the Islamic State.
Headwind No. 3: Gains in the Greenback
One other variable we didn’t discuss previously was the strong dollar. I am not convinced this is a major factor, but it is a factor.
Some traders believe because oil is denominated in dollars, a stronger dollar will make oil more expensive for many countries and then demand will go down.
Normally, this would be a wash, as lower oil prices will offset the stronger dollar — especially in today’s environment, where the fall in oil prices is much more than the rise in the dollar.
Some analysts suggest that, when the dollar is rising, investors will need hedges like oil and gold to protect the purchasing power of their dollar.
This makes sense for gold, as investors have many choices to hedge themselves with precious metals such as coins, bars, jewelry, ETFs and mutual funds.
It’s more difficult to hedge with oil, and most will invest perhaps better choices like gold and silver.
Over a long period, I’ve found that the correlation between the dollar and oil is weak. There is some correlation as hedge funds influence the markets and participate in the dollar/oil trade.
However, the story regarding the bearish trend in oil has a surprising new variable …
Headwind No. 4: Saudi Arabia
Vienna, Austria-based OPEC has over 70% of global proved reserves and produces over 20% of global oil supplies. However, Saudi Arabia has always had the most influence among OPEC because it produces the most oil by far. (It also has huge oil reserves.)
OPEC is a cartel and oligopoly that influences global oil supplies and therefore pricing. Its ability to control oil supply and pricing, however, has been mixed for the past few decades.
In the 2000s, OPEC was successful for the most part in establishing discipline to set up supply quotas and global oil prices.
Most energy followers, including myself, were very surprised that Saudi Arabia has been acting independently when it comes to pricing and supply.
Saudi Arabia’s recent actions have shaken global oil markets.
Will the Saudis’ Strategy Work?
Last week, Saudi Arabia surprised the oil markets again by cutting prices to U.S. markets but raising them in others.
Naturally, financial media has been speculating why the Saudis are doing this. Some “reasons” include:
- Punishing Russia for supporting the Shiites and the Syrian Assad regime
- Protecting their market share via price competition.
- Making U.S. oil shale to be uncompetitive so it can take back market share here.
Some analysts believe the U.S. will end up pressuring Saudi Arabia to back off its current strategy to lower prices in order to protect their global and U.S. market share.
OPEC will decide on Nov. 27 how to proceed on production quotas for next year. This will be an important meeting for the oil markets. Expect pressure from members of OPEC on member countries to lower production to increase prices.
Meanwhile, an OPEC official stated last week that it would support prices if they went below $70.
This brings up the best surprise yet …
Oil prices now have a floor. They have been rallying on this news.
With that in mind, look at this five year chart for WTI:
Let’s examine what’s taking place here:
- Oil remains in its long-term $70 to $110 trading range that dates back to 2010.
- There was support at $85 that goes back to 2012. Prices broke decisively below this support in the past few weeks.
- There was also some short-term support at $80, but prices broke that support as well.
- There has also been long-term support at $75. If prices don’t hold at $75, the next support is around $68. Again, $70 is the price that OPEC stated it would support.
- Notice the increased selling volume this year. Some of the sellers are shorts, so eventually we could get some rallies as the shorts cover.
- This bear market in oil and oil stocks is setting up the opportunity for investors to snap up some real bargains.
In addition to all this, natural gas and natural gas stocks seem to be stabilizing, so there’s a good chance I may recommend buying natural gas stocks sooner rather than later.
As I have written for the past few weeks, it is important to wait for prices to bottom and base.
Remember, bases are like diving boards. The shorter the diving board, the shorter the bounce. The longer the diving board, the bigger the bounce.
It always pays to know when to keep your powder dry vs. when to strike. Once we seem some true basing in the oil markets, I will start recommending energy stocks again.
And while prices may be low right now, I think we’ll see some bigger bargains a little closer to year-end — and that will be because we should see a solid base from which they can bounce higher into next year and beyond.
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