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Beat The Oil Trap

by | published September 25th, 2018

Crude oil prices are moving up again. The most immediate fuel this time is coming from a refusal by the Saudis and OPEC to increase production. That decision not to move came after a futile attempt by Trump to jawbone the cartel into increasing prices.

Almost lost in the geopolitical jousting, was a similar request for an increase in production from major non-OPEC customers China and India.

The Saudis have already announced that they are comfortable with oil prices being in the $80-a-barrel range, a position reflected by Russia (the main outside producer in the so-called OPEC+ production accord agreed to last year to bolster market prices).

As I write this, Brent (the primary worldwide benchmark for oil trade set daily in London) is sitting at just below $82 a barrel. A number of analysts now regard a figure approaching $90 a barrel is likely by the end of this year, with Brent having the potential to approach $100 by the end of the first quarter in 2019. (I’ll talk more about this figure in a moment.)

But no pricing rise is uniform, even if the underlying dynamics seem as clear as this one. There is a bump that may hit early next year that may arrest for a time an otherwise accelerating advance.

This is the “oil trap.” And you can beat it…if you know what to expect.

Oil Prices Will Continue to Rise – But There’s One Tiny “Bump” In The Near Future

The constriction in aggregate global supply remains the primary reason for the upward estimates. Over the past several months, worldwide production had declined at least 2.8 million barrels a day through the end of August. The slide is primarily because of internal problems within three OPEC members: a massive and historic contraction in strapped Venezuela; an ongoing civil war in Libya; and rising civil security concerns in Nigeria leading to a significant decline in available oil development investment.

And all of this is transpiring before an appreciable cut in Iranian oil exports expected following the renewal of US sanctions on November 4. That merely accentuates the supply side situation.

I released my current estimates yesterday. Assuming the market environment remain the same (a necessary caveat these days), I put Brent at $90 a barrel by the end of the fourth quarter, $100 by next April; WTI (West Texas Intermediate, the benchmark employed for futures contracts written in New York) should be at $84-$86 and $90-$92, respectively.

The rationale is transparent. While we certainly are not worried about a genuine crude oil shortage (the advent of massive new heavy and shale/tight oil reserves worldwide putting the “peak oil” debate to rest), the near-term outlook is for a tightening of supplies.

I am further estimating that the Venezuelan, Libyan, and Nigerian declines, combined with the significant cut in Iranian supply should amount to a further decline of some 3.3 million barrels a day of available exports by the time we enter December.

This dwarfs the upwards to 1 million barrels a day increase approved by a sidebar Russian-Saudi agreement that kicked in two weeks ago.

Export figures more than overall production is a more important barometer of the net impact on forward prices, since those prices are now influenced by the demand levels in the import-dependent regions of Asia and the broader developing world.

What is currently happening in Iran, even before the sanctions officially hit, is already exceeding the decline anticipated. Iranian daily crude exports should average 1.8 million barrel this month, down from 2.3 million in July. I am now estimating that that figure could be as low as 900,000 in November, a net loss of 1.4 million barrels a day in less than three months.

With OPEC spare production capacity is no more than 2.8 million barrels a day, with way more than 60% of that Saudi, the International Energy Agency in Paris has put the potential non-OPEC production increase at 2 million barrels a day for all of 2018, but declining next year. The bulk of that is Russian and US.

But we shouldn’t expect this tightening to continue completely unchecked…

Expect Briefly Lower Prices in Early 2019 – and Play The “Trap”

I discussed at length why this is a tightening situation in the last Oil and Energy Investor (“Here’s How to Play the Next Oil Wave,” September 20, 2018). I encourage you to review the play there – the United States Brent Oil ETF (BNO), both as a straight investment and as an options move.

Given the higher sensitivity in Brent pricing to geopolitical developments, the bigger pop is likely to happen there.

But as I said earlier, no pricing rise is uniform. And even though the broader outlook is still a tightening situation, we may still see a temporary production “bump” early next year that could create a trap for us as bullish investors – if we are not careful.

Briefly this amounts to two elements occurring in tandem. First, there are strong indications that production will briefly spike both inside and outside OPEC in January. These may not be sustainable longer-term increases, but will put some downward pressure on how fast the price will be increasing anyway.

Second, as prices continue to increase, some slowing in demand may be experienced in Asia (the drive of all things related to oil prices). This occurs whenever pricing spikes and reflects a truism witnessed in the market for decades. Rapidly declining prices encourage more demand for cheaper oil and refined oil products; quickly rising prices translate into less.

All of which means I foresee a slowing of the pricing rise for a period early in 2019, despite an ongoing trajectory moving up. As such, this “oil trap” is best played by using the BNO options “strangle” I recommended last week.

Sincerely,

Kent

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