May 05/15 – The coming collapse in the crude / whale oil spread

2015-05-05 9am EDT  |  #Dennis Gartman #Gary Shilling #oil #Saudi Arabia

Do you remember all the hysteria about the oil crash a few months ago? How can you forget the famous Dennis Gartman crude will “go the way of whale oil” comment? And then this “Get Ready for $10 oil” Gary Shilling Bloombergview piece in mid-February certainly helped with the bearish sentiment. By the beginning of March, the “market experts” were so worried about the growing storage glut, they were predicting prices could fall all the way to $20:

"The fact of the matter is we are running out of storage capacity in the U.S.," Ed Morse, head of commodities research at Citibank, said at a recent symposium at the Council on Foreign Relations in New York.

Morse has suggested oil could fall all the way to $20 a barrel from the current $50.

I don’t mean to pick on Citibank’s Ed Morse, the reality is he was far from alone with his bearish views. Oil had fallen from $95 to $50, and the market, as usual, could only imagine this trend continuing forever. The marketplace was filled with shrill calls for a crash in oil. Anyone who wasn’t predicting the continuing decimation in the price of oil just didn’t get it.

Yet at the time, I stressed that the market was getting too bearish, and that oil would stabilize, and meander between $55 and $70 for quite some time. Now I am by no means taking a victory lap on oil because I was early in my bullishness. All traders know that being early is pretty well just as bad as being wrong. I started buying in the low $50s, and I never imagined it would go all the way down to $45. And there was some dark moments down there where I was pretty lonely.

But I think it is helpful to remember what caused this decline in the first place. Although the narrative is now focused on all the excess supply from the US shale oil producers, the actual decline was triggered by the Saudis undercutting world oil prices and then flooding the market with oil. It seems like everyone has forgotten, but the Saudis aggressively sold down oil last fall. There was talk that this was a strategic move orchestrated by the Saudis and the Americans to punish Iran and Russia. Who knows whether this was true or not. It could be the Saudis saw the coming supply and realized that the price was headed lower, so they might as well send it lower by picking up market share. But there can be no denying that their move to undercut the world price triggered the cascade of selling.

As the selling accelerated, there was considerable pressure on Saudi Arabia from OPEC nations to cut supply to stabilize prices. At the time the Saudis refused to budge, and just kept pumping.

But as crude tumbled through $80, and then below $70 and then finally below $60, the Saudis finally gave some guidance on their views for the price of oil. From the WSJ in late December:

LONDONOPEC's biggest oil producer, Saudi Arabia, now believes oil prices could stabilize at around $60 a barrel, a level both it and other Gulf producers believe they could withstand, according to people familiar with the situation.

The shift in Saudi thinking suggests the de facto leader of the Organization of the Petroleum Exporting Countries won't push for supply cuts in the near-term, even if oil prices fall further.

By this time it was too late to alter market sentiment. The bearish theme had enveloped everyone’s thinking. The price continued to plummet, with $60 quickly giving way to $50, $48, $46 and finally $45.

I never expected the market to get so beared up on the price of oil. I guess I underestimated the amount of weak longs in the market. But at the same time, I held fast with my bullish views. I believed the price decline was a managed campaign by Saudi Arabia to shake out the over leveraged players (and at the same time hurt Russia and Iran).

And just like that, over the past month and a half, the price has rallied from the $45 level in mid March to the $60 level this morning. Although there are now a few longs highlighting their bullishness, for most of the rally, sentiment was uniformly bearish. Every price rise was met with calls that the filling US storage would catch up with the market and that price would soon collapse. There has probably been no better example of a market climbing a wall of worry than the recent rise in crude oil.

Now here we are, at the $60 price that Saudi Arabia predicted oil would stabilize. The bears are still confused at how the price has risen in the face of the growing supply. But they forget that oil is a global commodity, and although there are some vagaries between the various delivery points and different blends, at the end of the day, the oil price is set by the last marginal barrel in the world market. Saudi Arabia is one of the world’s largest oil producers, and they are best able to turn on and off the taps at their will. If Saudi Arabia wants $60 oil, for the short to medium run, they are able to get it.

Saudi Arabia orchestrated to push prices down, and even they probably didn’t expect the swoon to $45, but they are just as easily able to ease up on the pumping to get prices back up. I am not surprised by the move back to $60, for me the real surprise is why crude prices ever got so low in the first place.

Even though it is now easy to imagine the price continuing to rise, it is probably time to take a deep breath and not chase it higher. There are still a lot of offside North American oil producers. Oil rallies are going to be met with selling from these players. Could we rally another $10 in the short term? Maybe. But my suspicion is the $60 price will be the anchor in which oil prices gyrate around for the next year.

The market got overly bearish below $50, and it is probably getting overly bullish above $60. I know this is a boring call – no one wants to hear preaching to not chase the market. There is a reason that the technical calls to “buy it if it breaks above X, but sell it if Y support doesn’t hold” are so popular. People love to chase. I just don’t think it will make you any money when it comes to crude.

As the market breaks above $60 in the coming days, the calls for a new bull market in crude oil will fill the airwaves. Ignore them and don’t forget it is was only a couple of months ago that crude oil was going to be as useful as “whale oil.”


Oil vs. 5/30s

Now don’t get me wrong – I don’t think you should short crude oil. Over the long run, I am a big oil bull (even though Dennis tells me that the crude / whale oil spread will collapse). I think the surprises will be on the upside, not the other way round.

The world economy is improving and this will keep a decent bid to crude oil.

If so, what does this mean to the other markets? Have a look at this chart of the US Treasury 530 yield spread versus crude oil over the past half a year.

The curve has been moving almost lock step with crude oil. And if anything, the curve is predicting a little more upside in the crude oil price Hmmm. Maybe I should chase oil after all

Thanks for reading,

Kevin Muir

the Macro Tourist