A quick (and simplified) overview of the oil price development, including Iran ramping its production, Saudi-Arabia refusing to cut production, overflowing storage and the risk of rogue contango.
What I’m doing about it, i.e., my personal investments – tactical and strategical.
And some ducks… (and doomsday scenarios). And DIKs
Readability: Including the summary, and this, it’s a fairly quick and easy read at 2068 words.
The table below shows my (simplified) view of the oil situation. I assume you are a grown up that understands it’s not the complete picture. I also assume you understand I’m not recommending anything. It’s all just entertainment. Disclaimer here.
To the left are variables supporting higher oil prices
To the right are variables that could cause significantly lower prices again; possibly new lows
|Broken oil producer budgets||Iran ramping production|
|Storage situation exaggerated||Saudi-Arabia wants shale out|
|Price momentum||Marginal storage left for futures arbitrage|
|Potential production cut||Recession is coming, lower demand*|
|Capex cuts||Dead cat short squeeze bounce ending|
|Strategic bombing = prod cuts||(renewables – long term)|
|I’m selling oil :)||Bust shale assets bought cheaply|
It’s all Bernanke’s fault, just as everything else
The story so far: low interest rates and QE drove higher oil prices as well as heavy (mal-)investments* in shale production. (*investments that only made sense in ZIRP La-La land).
Once enough new capacity was in place (it took a few years to complete the malinvestment projects), sub-par economic growth (and thus lower demand) contributed to storage all but overflowing and consequently a sharp drop in oil price.
They key is OPEC and shale budgets
Saudi-Arabia, Kuwait and UAE have exacerbated the situation by increasing production in an attempt to fix their broken budgets (they need to sell more at lower prices) while crushing the shale industry at the same time.
Oil prices have jumped on hopes alone
Very recently, the oil price has bounced by more than 40%, due to short covering and speculation amid hopes of an OPEC production cut. Several countries, including Russia and Nigeria happily fuel such speculation (to mitigate their budget deficits).
Productions cuts are highly unlikely
In the real world, however, Iran is looking to ramp its production back to “normal”. Before that is accomplished, there is very little chance of any production cuts anywhere. This will take some time.
My guess is that oil speculators will be sorely disappointed when production cuts meetings are postponed or cancelled, while storage inches closer and closer to full capacity.
The storage crisis haven’t even begun
Nota Bene that storage isn’t full yet; that the storage crisis haven’t even begun. Also note that Iran is just starting to ramp, they aren’t actually producing more yet… It will probably take several more months to reach absolute full capacity in storage facilities, and several quarters or more for Iran to reach normal production levels.
Without arbitrage, exploding contango could obliterate ETFs
When there is no more room for front end/next month futures contract arbitrage, through temporary storage (when back yard containers of barrels are full, as well as tankers and ordinary storage), there could and should be a devastating price plunge in the front end contract. The resulting massive contango (Next month’s price less this month’s price; which could be repeated month after month) will erode any investment based on rolling oil futures forward, e.g., through an ETF like USO or Olja S.
Just knowing about it doesn’t fix it – that takes time
This situation could go on for several quarters, maybe a year… or more, while Iran is increasing its production and OPEC is falling short of promises of production cuts again and again, perhaps most notably at the supposed meeting on March 20.
Due to the reasons stated above, I have sold my Brent ETF (Olja S) as well as the oil junior ShaMaran (which is still waiting for its “first oil” and has some cash flow problems, but trades at what might turn out to be just 1x P/E a few years hence).
I’ve also sold some but not all of my DNO shares. DNO could be a strong Buy for the coming 3 years, but there is a definite risk of a deep downturn before that, even if the company doesn’t have the same financial problems as ShaMaran.
DNO is probably a much better bet already at current prices than any oil futures ETF or derivative.
Don’t short what should eventually double
I won’t go short though. And I’m actually not that confident in cancelling my longs either. The reason is that a sustainable oil price probably is somewhere between 60-100 USD per barrel for the coming few years (rather than the current $40), once the current storage crisis is sorted out. In between however, the front end contract could easily fall back to 30 and even below 20 USD/barrel.
In any case, I’m expecting a quite prolonged storage crisis, up until Iran is content, shale is dead, and Saudi-Arabia, Kuwait and UAE can agree on the necessary cuts. I plan to buy more DNO, ShaMaran and USO long before that of course, but only when Iran has ramped significantly or we’ve hit new lows for oil, oil companies and the stock market in general. This might happen already this April,or as late as April 2017.
We’ll see. I’m not sticking around for the downturn, except maybe with a marginal position in DNO.
If it walks like a duck, talks like a duck and looks like a duck, it probably is a duck.
Oil prices pass the duck test of a recovery: unsustainably low prices, rising, breaking key levels, talks of production cuts…
On the other hand, so do storage problems (which pointy in the opposite direction): almost full, meaning the real problems haven’t even started, Iran not backing off, neither is Russia or Saudi-Arabia. Shale still lingers as the walking dead.
Another walking, talking, living, sitting duck is the economy. Most pundits talk of low risk of recession. However, a select few, very mart people, point to a combination of factors: duck tail, duck beak, duck feet, duck feathers, duck calling sound etc., all clearly pointing toward there being a recession duck swimming around in plain sight.
I’m squarely in the “dead cat bounce” camp regarding the oil price and stock market, and in the “given these variables, including the stock market there is almost invariably a recession” group of people.
One caveat though: In 2009-2012 I used to say “this won’t be too bad if we normalized rates to 4% and some other things“. Now I’m leaning more and more toward “we are beyond thinking about investments, and more about defending civilized life as we know it“. I’m sure many more make the same assessment, including policy makers.
There is no turning back from full retard central bank policies
That means the powers that be truly will do “whatever it takes” (as Draghi’s Full Retard Threat went back in 2012) for as long as they can, thus making the final crash even worse.
As time passes and policy makers venture further and further into retarded measures, I’m becoming less and less certain of my forecast of a “pretty bad but not catastrophical outcome quite soon“. Instead I see increasing risk of a blowout on the upside followed by something on the downside we haven’t seen since the 1920’s crisis in Germany and the Great Depression in the U.S. in the 1930’s.
The best long term outcome would be a normalization of stock markets, interest rates and debt burdens as soon as possible. There actually are some promising signs in that direction. But then again, there is Draghi (ECB), Ingves (Sweden) and Kuroda (Japan) trying to get into the history books with a particularly toxic variation to the Rio Spread Theme*. Maybe war is the only “solution” after all.
*The Rio Spread means taking a huge bet in the market and going to Rio for unlimited celebration. If it works out, it works out. If not, you stay there. The DIKs (to which Mark Carney of the BOE is very close to being added) will either miraculously save the economy, or (much more likely) ruin it completely. Either way, they will get their place in the history books.
I think the ECB reaction was quite expected (except the rebound afterward). The Fed is more important though. My guess is we’ll get the exact same reaction after the FOMC meeting (except the rebound) as after ECB, i.e., reflexive buying followed by heavy selling.
How an economy grows
I listened to a typical economist today (on the Swedish podcast Fondpodden), and she said the same stupid interventionist and illogical things about deflation and growth that most academics do (except that she didn’t defend negative interest rates). I just want to set the record straight as an antidote to the brain poison she helps spreading:
Saving enables investments which lead to better tools and infrastructure and thus increased productivity and falling production costs and selling prices.
Falling prices typically lead to increased consumption, but if it doesn’t, it means more room for even higher savings and investments and higher growth.
Somehow many economists have misunderstood this completely and think that lower prices (like spring sale, summer sale, Christmas sale etc.*) mean less consumption. And even if it does, what’s bad with that? Nothing! people will buy what they want and need, no matter the direction of prices. And if they were to limit their purchases somewhat that only means more saving and room for investments and even higher growth.
So, saving=>investment=>low prices and high growth=>both increased consumption and investment and thus even higher growth in a virtuous cycle.
Most economists want higher prices, which lead to less room for consumption and investments and thus both lower supply and demand => lower growth, less wealth, even less room for saving and investment, and so on and on in a death spiral.
*Actually, they claim there is a difference between sales and declining prices. They think lowered prices increase consumption while falling prices decrease consumption. Eh? Somehow, falling prices on TVs. cell phones and computers increase consumption, while falling food prices lead to people eating less… Eh*2?!
Invest responsibly. Remember that investing is 80% psychology. The other half is patience.
Summary – selling oil, waiting for abundance
In short, I’m selling oil due to the storage situation, that will only get worse until Iran has reached full production and OPEC cuts can be seriously considered.
I don’t dare shorting though. Quite the opposite; I’ll look for (oil company) stock bargains in the expected carnage (blood in the streets).
I’ve gradually had to “refine” my general outlook from “bad” to “binary”. I’m staying short the stock market but even that feels less and less palatable these days. Gold and silver are the only things that feel OK. I’m even leaning closer to getting some physical gold to complement my paper gold. So far, however, I haven’t, and I just don’t want to be that pessimistic.
I mean, the 2020’s promise to be the best era ever (so far) for humanity, with widespread abundance provided by AI (did you see AlphaGo’s victory?), nanotech, biotech, robotics etc. Billions of people coming online, sharing knowledge and using ever accelerating technological tools to create more and better solutions to everything than at any time in human history. And then we haven’t even mentioned the 2030’s!!
We just have to pass this little “bump” provided courtesy of Draghi, Ingves, Carney, Kuroda etc. (including Yellen of course, but she’s no DI…)
What goes bump in the night?
I want to put my wisdom in you
I may have gone overboard with that Will Ferrell-inspired book cover I tweeted the other day (the Tweet, viewer discretion is advised).
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Aware of themselves, aware of the world, aware of their career possibilities, of their investment opportunities, of the fantastically bright future that awaits.
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