There's been some agreement inside the analyst community on oil: $70 per barrel is not sustainable, because several producers don't have the prime acreage or debt positions to survive. The number of requests for rig permits is already dropping, capital expenditures are being slashed. Production growth will significantly slow, if not reverse, in the next six months. Knowing all this, why can't crude oil rally?
This is where I come in and try to explain the vagaries of financial oil markets. Again and again, I try to show how the financial aspects of oil overwhelm the fundamentals and play havoc with them, delivering counter-intuitive price action. Charting the money flows into oil will show why the oil market is destined to stay low for an extended period of time, even perhaps after the glut begins to clear, and U.S. oil production starts to drop.
All of these reasons have nothing to do with supply or demand, and they are entirely financial, but they describe why oil will continue to be weak for the next six months.
1. Exploration and production (E&P) panic: oil companies trying to avoid default risk are more apt to hedge oil futures at $65 than they are at $75. Even though these hedges are below breakeven prices for many of these companies, they could mitigate the immediate risk of bankruptcy, should oil go down to $50 a barrel. This is a market that breeds selling as it goes lower.
2. Investment Bank marketing arms gone: one of the results of IB marketing of alternative assets was a continued supply of retail buyers into the commodity space, particularly oil. Much of that 'bid' is gone now, as U.S. investment banks have given up on their trading desks in oil and other hard commodities.
3. Passive commodity index funds are leaving: an incredible commodity deflation (including oil, base metals, and grains) has forced passive indexers of commodities into sell mode. The redemptions on passive indexes are at a level not seen since 2008.
4. No good retail thesis to buy oil: in the past, you could have made a case that commodity inflation had to accompany growth in the U.S., but you can't make that case anymore. Further, while geopolitical unrest in the Middle East and Russia had been terrific incentives to bet on supply shortages in the last 10 years, the markets are suddenly entirely unimpressed with them today.
5. The dollar remains strong: with every Asian and European Union nation chasing devaluation, the dollar will continue to show strength, adding pressure to oil prices.
Combine these five factors, and you've got little reason to expect an oil rally in the near future. In fact, I'm looking now for truly bullish hard numbers to reappear, to finally inspire any new bid in the oil markets. That might include a real drop in U.S. production in shale for the first quarter of 2015, a few mergers, or outright bankruptcies of smaller U.S. E&P companies, and perhaps an indication that the European Central Bank easing is adding support to EU markets. It wouldn't hurt to see gasoline demand increase from lower prices as well. An even bigger upswing in truck sales would be a good initial sign of that.
Those indications are, I believe, at best perhaps five months away, or they may actually appear by tax time in mid-April. Until then, expect a continued low oil price. Every rally, no matter how small, needs to be sold.
