Crude oil and the economic cycle

January 14, 2015 06:45 PM
OPEC Market Share

OPEC Market Share

When U.S. shale oil production continued to soar and cut in on OPEC’s market share, the Saudis said enough was enough. The Saudis tried to laugh off the U.S. shale revolution, but then the laughter stopped. Fortunately for U.S. consumers, the threat of lost market share was greater than the pain of lower prices, so OPEC was forced to compete on price. OPEC, who, let’s face it, is controlled by Saudi  Arabia, made it clear by their price-cutting and their refusal to cut production that they wanted to target North American shale oil producers whom they view as a threat. The volatility has provided opportunities for traders. 

Ever since OPEC challenged U.S. shale producers by refusing to cut production and offered discounts on price to crude oil buyers, oil prices have plummeted in one of the five most dramatic sell-offs in oil history. OPEC and Saudi Arabia showed they were serious when they lowered their demand forecast for their oil to 28.9 million barrels but continued to produce 30.05 million barrels per day. It has been a while since OPEC has been on the fear side of the fear/greed conundrum. 

While many might like falling gas prices in the short run, the long run is where we are going to see the bulk of the oil movement and pain. The price crash exacerbated by the Saudis, will only slow oil projects and create the environment for price spikes in the future. It can actually hurt the global economy by slowing worldwide economic growth. We could end up in the muck of what might seem like a never-ending oil glut, not even knowing we are setting the stage for a price spike down the road.

 The first sign that the Saudi price cuts were having an effect on production was when we saw new oil well permits fall 40% in November in key shale production areas like Permian Basin, the Eagle Ford and Bakken. We then heard energy companies big and small react to the plunging oil prices. ConocoPhillips said it will reduce investment spending by 20% next year in response to the price drop. BP said it will cut hundreds of jobs across its global oil and gas business by the end of next year in a $1 billion restructuring. 

There are reports that more than $150 billion worth of energy projects are being put on hold as OPEC has added more uncertainty to the global market. Rystad Energy pegs the global average cost of production around $82.50 a barrel next year due to rising production costs, which means that we won’t be adding to global production capacity at a rate that will allow us to meet potential future demand if and when the global economy starts to expand.

While oil prices would eventually have sold off into the ’60s without the Saudi Arabian production decision, because of the way it happened with the shocking price drop, projects that should have been completed will not get done. This means that production growth in the future at some point will not keep up with demand. While the crude oil market is wildly bearish in the short term, the cutbacks in spending and investment in oil are setting the stage for the next bull market years down the road. History has shown us that when oil prices fall dramatically, the lack of investment in energy comes back to haunt us in the future. While that risk would be less if prices fell normally, the Saudis essentially dumping cheap oil on the market means the sharp drop in projects will cause tighter supply down the road.  

While prices may still have farther to go on the downside in the short term, face it, if you are not already short, you may have missed the bulk of the move.  

Traders need to look at capitalizing on a move that may be coming three to five years down the road. One way is to do a spread selling nearer term crude and buying a further out contract. This is a long-term play so we are not talking buying the front month and selling the next expiration. A spread one might try is to short the December 2017 futures and buy the December 2020 futures (see “Long-term crude,” right). This spread could move out to as much as $10 once the effect of low prices causes production to shut in. 

The other way is to buy options further out in the future. Look for value when there is weakness in the front end of oil and buy longer term. You can also sell calls in the front end of the curve and hedge with calls longer out. Just as high prices were a cure for high prices, low prices will cure low prices. But it will take some time. Even though it may seem that this glut is here to stay, in time it will be a distant memory. 

Phil Flynn is senior energy analyst at The PRICE Futures Group, a Fox Business Network contributor and regular contributor to futuresmag.com.

About the Author

Phil Flynn is a senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. Phil is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets.