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Why Oil Will Peak on Friday

Texas tea has undergone the perfect storm over the past month, with the Middle Eastern dominoes falling one by one. It was the worst case scenario times five, and all of a sudden my once outrageous claim that crude would hit $100/barrel by the end of first quarter seemed positively conservative. On Friday, we face a “Day of Rage” that threatens to topple the Saudi regime, a 12 million barrel a day exporter.

Don’t kid yourself. The real price of crude oil now is $120/barrel. That is where both Brent and Louisiana sweet are trading when you adjust for the term structures in the futures market. The $107 you see trading on your screen on NYMEX is for delivery in Cushing, Oklahoma, where prices have been driven artificially low by a glut of crude coming down from Canada and North Dakota being dumped in a market where there is no storage. According to the CFTC, the net long of 268,000 oil futures contracts in the market would fill all the storage in Cushing six times over.

But Saudi Arabia is not Tunisia, Algeria, Egypt, or Libya. The latter countries had shaky regimes that were established during the postwar era that were built on sand. Saudi Arabia has been around a lot longer. It is based on a series of inter-tribal marriages between tribes that took place during the early 1920’s that remain rock solid today. Being the wealthiest country in the region, the Saudi’s had a lot more money to spread around to keep everyone loyal. This is why Al Qaida has made absolutely no inroads there for the past 20 years.

This is all a long way of saying that Friday’s event in Saudi Arabia will amount to a big nothing. In fact, I don’t think we are going to get much more out of the entire Middle Eastern crisis. The Libyan civil war seems to have quickly stalemated. The military there is actually quite small, as Khadafi sought to minimize the threat to his own regime by a coup‘d etat. After all, that’s how the young colonel gained power himself in 1968. And no one on either side has any experience fighting, or organizing a military campaign of any kind.

There are other factors to consider. Even a token release of oil from the strategic petroleum reserve, which the administration seems to be considering, could be a real price killer. This is how the last two great price oil price spikes ended. Ben Bernanke’s QE2 ends on June 30, which has poured hundreds of billions of dollars into gold, silver, agricultural commodities, and yes, oil. The end of this program could cool the hugely inflationary pressures on all “hard” assets.

So I think that oil is peaking here for the time being. All of the $23, or 27% increase in the price of oil in the last four weeks has been about fear. Only 1 million barrels a day, or 1.2% of daily global consumption has actually been disrupted, and that can easily be made up by boosting Saudi production, which they have already generously offered to do. Anyone in the oil industry will tell you that, considering only the true supply and demand for oil, the price should be about $70/barrel.

Mind you, I am still a card carrying “peak oiler.” I think it is just a matter of time before we hit $150/barrel, and then $200. But we have covered an awful lot of ground on the upside in a very short time, so it is time for a rest. I think we are going to see $90/barrel before we see $150.

There may be a trade here for the nimble. You can look at the inverse oil ETF (DNO). You can buy out of the money puts on the oil futures. I think $100 out three months would be a nice cheap strike. My favorite would be to buy puts on the Oil ETF (USO). Here the ETF with the world’s worst tracking error will work to your advantage to the downside.

By. Mad Hedge Fund Trader




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  • Anonymous on March 08 2011 said:
    I wouldn't be so sure Saudi has much spare capacity, and what there is is their least wanted stuff - heavy and sour, while Libya's oil is light and sweet. The refineries in Europe are geared to light sweet grades, so the Saudi grades should go to Asia, and their lighter grades should move to Europe. It is difficult to see this happening smoothly.What no one is mentioning is that the result of the current instability could be a war where each side trashes the opponents oil infrastructure, as in Iran-Iraq in the 1980s. This would reduce production for several years, regardless of the political outcome. The resulting chaos on financial markets would drag the world economy back into recession (for the second time) as we bump our way down the post-peak side of Hubbert's Curve.

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