Category Archives: Commodities

Crude Oil Thesis for 2015

Anyone who hasn’t been living under a rock knows that crude oil prices have absolutely plummetted in 2014.¬†Oil prices experienced their second largest annual decline ever and ended the year at a 5 1/2 year low. West Texas Intemrediate crude (WTI) fell 46% for the year while Brent fell 48% for the year. Many analysts predict a quick recovery in oil prices back to the $70 region but I beg to differ.

Let’s assume no new shocks to supply or demand such as a huge middle east crisis that cuts supply immediately, or OPEC calling an emergency meeting and saying they are going to drastically cut production to support prices, or China suddenly achieves 10% growth and starts buying up the world’s oil like what it did previously with iron ore and copper.

If the above stays true, then I believe oil has a very high chance of falling lower. I wouldn’t be surprised if WTI reaches low $40s, and Brent mid to high $40s. Most analysts, especially those at banks who cover equities, think that oil has bottomed and will recover, probably by end of next year. While it could be true that oil will start recovering by end of next year, I do not believe that it has bottomed. The bulls’ thesis is that most US shale wells have a breakeven of >$70-80 so they will cut production and new wells will stop being opened. However, they are confusing the breakeven price for greenfield projects and for mid-stage/cycle projects (projects that have already started). Yes, in many of the shale basins except for maybe parts of the Marcellus, Bakken and Eagle Ford basins, it is uneconomical to buy land leases, apply for the permits, buy the equipment and start drilling. However, if the process has already been started and lets say the land has already been bought for example, the company is still going to proceed with the project to get back some return. After all, whatever investment it has already made is sunk and they need to continue the project to get back some cashflow, probably to service some debt. Hence, the US shale supply will take quite a bit longer to start responding to this lower price of oil.

The above analysis assumes that OPEC (Saudi Arabia) is trying to achieve economic aims. There’s another argument that Saudi Arabia is actually looking at this from a political angle (which it has had a propensity to do so, as recently as 2008). Saudi Arabia fears USA’s rapprochment with Iran. By depressing oil prices, Iran’s influence is significantly curtailed since their budget deficit is going to be so large. Some point out that Saudi Arabia also needs a brent oil price of ~$100 to balance it’s budget, but they forget that Saudi Arabia, along with Jordan and Kuwait, have built up reserves equivalent to more than 5 years of their annual budget expenditure. Hence, they are able to endure through this short term pain and this means that prices can stay low for an even longer period of time.

So far, we have talked about the fundamentals of the oil market. The stocks situation of oil is definitely still building, and this can be seen in the forward curve of both brent and WTI, where the contango has widened. One problem of futures curves though is that they tend to reinforce the flat price trend. So in this case, as the contango widens, it gets more and more costly to be long the front end of the curve because of the negative roll yield. Thus, many longs will be slowly forced to cut their position. This long liquidation will act as a further overhang in the market, until a positive shock to supply or demand emerges. Potential new longs will stay away due to the higher cost of carry. I think a good analogy of this is a poker tournament where a player is busted out not because he lost money in a pot, but because he kept having to pay blinds. Moreover, the prices of both WTI and Brent have been consolidating the past 2 weeks, and at times have actually bounced a bit (though very briefly). From the commitment of traders report, we can learn that this is due to new long positions from non-commericial players (basically funds). I feel that if oil starts falling a little or shows no sign of recovering soon, then these longs will liquidate and move their money elsewhere. This will serve as a second overhang.

Thus, I’m very bearish on oil, both from a fundamental and technical point of view. I think it will fall further and not recover until late next year at the very earliest. I recommend any bounce as an opportunity to sell. I’m happy to sell short both WTI and Brent crude futures. However, if I had to pick between the two, I would choose to short WTI. US crude stocks should continue to accumulate as shale oil production is maintained in 1H15. Brent futures also run the risk of being more impacted by a supply shock in the world such as a middle east supply disruption.