News Features Energy News The “Upside of Down Oil”

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Pulling the trigger on investing opportunities can be difficult at the best of times. To step back and see the bigger perspective might help a DIY investor to understand the short term market anomalies that otherwise keeps them awake at night. Lately, it's been declining oil prices. What is underlying such a dramatic shift in the price of oil, and is it yet time to invest?

Let's put this into context.

Declining Oil Prices

If you own an oil stock, it's a miserable time. In less than 6 months, most of the producer stocks are 50% or more off their highs. Oil drilling technological advances in the West have created increased supplies at a time of waning global demand due to economic slowdowns in major regions around the globe (ie., Europe, Japan, BRIC's). This is a secular shift in the supply/demand metrics. The reservoirs of the world are overflowing. More oil cannot be stockpiled except at higher and higher costs. Even the world's largest supertankers are being rented out by oil traders to store excess capacity.

This pressure on current oil prices has resulted in something called the "Contango Effect". Normally the current price of a commodity is higher than the price of a future for that commodity. With oil being in such oversupply, it has resulted in the current price being lower than the futures contracts, therefore making it more valuable for oil traders to hold onto the physical commodity and to deliver the oil to a worthy destination at a later time. This is a temporary but disruptive process. How does the market remedy this dysfunction? Normally this is the signal to stop producing oil and let the excess be absorbed. But oil production is carrying-on unabated. Why is this and when will it stop?

Oil as a Proxy

We need to keep in mind that oil is not just a commodity that serves to fuel the world's machines, it is also a proxy currency used by despots and dictators. To Russia, Iran, Venezuela, Nigeria and Saudi Arabia, it is their primary source of revenue. Their annual budgets rely heavily upon oil & natural gas revenues. They produce oil to garner hard $USD to help fuel their budgets. In the alternative universe where capitulation is a sign of weakness, none of them want to be seen to be "blinking" by arresting their oil production. If they stop production, they will lose market share, particularly to the Western private companies with all of this new drilling technology & capacity. The price of oil has been sliding because the usual forces of supply and demand have been truncated by political wills. In the interim, these despotic states are hoping that global demand perks-up and absorbs the overflow and stabilizes oil prices at higher levels.

Unfortunately, most of their budgets (Saudi Arabia & Iran being the exceptions) require the price of oil to range above $65/bbl. If oil prices fail to recover in the short term, these political leaders-in-denial will be forced to make tough budgetary decisions. Social unrest will be a probable outcome. And although Russia has announced budget reductions, they intend to maintain their military budget. The most vulnerable regimes always favor military support over the needs of their people. Overall, because no one country wants to lose market share nor valuable hard currency ($USD), the oil spigots will continue running wide open. So, with oil prices having fallen from $95/bbl to near $50/bbl, is this now investing opportunity?

With the global economy expected to remain in a state of general malaise in 2015 (other than the USA), the price of oil will only likely begin to stabilize when OPEC chooses to curtail production or Western oil companies capitulate due to cost overruns. We're not there yet. With oil prices in the throes of a secular adjustment, this wrestling match should continue between financially prudent Western oil companies and the level of social (and therefore, political) unrest that can be tolerated within these pariah states. They have no other option. So, despite that it is economically unviable to keep up production to maintain market share, they will do it purely to keep those hard $USD flowing into their coffers. These oil dictators play this game because, to them, it is a life and death matter. If they lose their role as supreme leader, they will lose their life. For them, there is no retirement, only death or deposement to an off-shore island. So, without any expected imminent boost to global demand, there is likely to be 'blood in their streets' before an investment in oil stocks should be merited. And, when the blood flows, historically, that has always been the most advantageous time to invest.

Oil Causing Deflation?

Many economic pundits are now pointing to oil as the likely culprit in terms of the onset of deflation. Don't count on it. With oil ubiquitous as a resource in the world's standard of living, and with more cohorts of middle class consumers emerging, cheaper oil should only improve the demand component for improving global GDP. If there is oil-induced deflation, it will be reserved primarily for oil-exporting countries where un-diversified economies continue to be captive to political regimes. Because Canada is the world's 6th largest exporter of oil, it may also find itself labouring under some deflationary pressures and therefore further pressure on the "Loonie".

All-in-all, the short term still looks nasty for oil. In the medium and longer term, as a non-renewable resource, oil prices will rise once again as the machinery of the world economies sputter back to life. Keep your eyes on China.

With respect to deflation, the real culprit of a potential secular deflationary cycle for the rest of us emanates from the haunting oversupply of easy credit over these last 6 years and the 'hang-over' reality that lenders like to get repaid before they will lend further capital. That is how nominal global demand is currently being dampened. This is not an oil supply issue. Realistically, we haven't even yet begun to see higher interest rates being demanded for the actual growing risks.

The next stage of global economics will be the normalization of interest rates. Stay tuned.

http://blog.sprinklebit.com/upside-oil/

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