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Why Oil Is Going to Zero

By Mad Hedge Fund Trader | Mon, 26 November 2012 14:37 | 7

Every trader in the oil market is fascinated by the recent price action. The last few months have seen an onslaught of negative news developments that should have sent the price of Texas tea to the moon. Instead, it has fallen, from a high of $110 in February to as low as $84 last week. What gives?

Investors can be forgiving for thinking that oil should be printing $150/barrel here. It has been nearly six months now that the Iran oil embargo was expanded from the US to include Europe. The Islamic nation is now producing 1 million barrels less a day than it was a year ago.

Yemen, Syria, Sudan, and Kazakhstan are all offline here for a variety of political reasons. While with all small exporters, there was a day when the loss of even the tiniest incremental producer sparked a frenzy in the oil pits. Now we see hundreds of missiles raining down on Gaza and a further booster to the geopolitical bid for oil.

The normal explanation is that the market is anticipating that the economy will plunge into a headlong recession in 2013. But the economic data is not indicating that anything like that is on the immediate horizon. To find an accurate explanation we will have to delve deeper into the black commodity's long-term fundamentals.

Saudi Arabia has been the major factor, offsetting OPEC production elsewhere with increased production of its own. The kingdom is now pumping 11.5 million barrels a day, an all-time high, and is thought to have another 1 million barrels a day in standby production.

Libya has restored its own production to pre-civil war levels of 1.5 million barrels a day. It turns out that both sides in the conflict protected the pumping facilities because they thought they would win, hence their rapid return to the market.

Some in the industry blame president Obama for slack prices. First, there was his jawboning about oil speculators in the spring, which prompted the CME to raise margin requirements for all commodities. There is no way that he was going to let high gasoline prices pee on his election parade this year.

Also important is that the US Strategic Petroleum Reserve is full at 739 million barrels, so there will be no incremental buying by the government. With the US headed for energy independence in the near future and about to become the world's largest exporter, there is in fact, no longer any need for an SPR. That would bring an end to lavish political pork payments for the storing states of Louisiana and Texas, which overwhelming voted red in November.

China has completed the first 110 million barrels of purchases for its own Strategic Petroleum Reserve. It will add another 400 million barrels by 2020.

It is clear that high oil prices are curing high prices. Oil hit a bottom of $10 a barrel in 1998, when it was worth less than the barrel holding it. That is when the industry obtained its last raft of tax subsidies from Washington. After that, it rocketed to $149. The big guess is how close we get to the last bottom. If world peace breaks out -- a distinct possibility if Iran folds its nuclear program in response to unremitting US pressure -- then oil could lose a risk premium that many in the industry estimate at $30-$40/barrel.

One certainty is that the next downturn could be much more exciting than the last. The arrival of ETF's mean the public now has much greater capacity to sell oil short, substantially increasing volatility in the next selloff.

Chinese government officials recently told me that in the 2020's the US will be the next China, thanks to a huge cost advantage afforded by cheaper energy. Given the recent price action. That could happen much sooner than they think.

Use every substantial rally to sell oil short, or buy puts on the United States Oil Fund ETF (USO).

By. Mad Hedge Fund Trader

Light Crude Oil - Spot Price EOD 2

United States Oil Fund LP 2

About the author

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Leave a comment

  • Gridlock on November 26 2012 said:
    Are you kidding me? Where do you really think the bottom is? I have a hard time seeing West Texas break much below $75.
  • ngass on November 26 2012 said:
    That article is very naive. Brent is around $110 and is the world standard. WTI is a local affair and the price is low, screwing Canadians since they cannot sell elsewhere.
    It is nonsense to expect crude for $30-$40 since the drillers will have shut in the wells long before. the shortage will make the oil price rise. Even the Saudis need $90/barrel to sustain their infrastructure and social programs.

    The US produces 6.5 Million barrels per day and imports 9 Million barrels per day. It is ridiculous to assume the US will be crude oil independent. All oil fields are in decline (especially the tight oil fields like Bakken Haynsville, etc) and it is expected that the US must import more oil if the economy gets better and people do not save energy.
  • David Hrivnak on November 27 2012 said:
    I fully agree Mad Max is dreaming. The ONLY reason we are seeing some gains in the USA is becasue oil is about $100/barrel. With one having to heat oil shale deposits to 800F for 3 years on average just to get it to flow, there is no way they will produce at a price of $50/barrel.

    Canadian tar sands are in a similar boat having to dig 4000 lbs of gooey sand and treat with 120 gal of water for 1 barrel of oil. Oh and then one is left with 4000 lbs of contaminated sand and 120 gal of contaminated water.

    It is time to go electric drive and leave the oil companies behind.
  • FredB on November 27 2012 said:
    The title says Why Oil Is Going to Zero. The article says oil prices could drop by $30 to $40.

    I hate it when you do that.
  • kito on November 27 2012 said:
    ha ha, this author has the sheer audacity to make such fallacious statements as "With the US headed for energy independence in the near future"!!!!!! talk about self serving nonsense. how, mr mad trader, is the us headed for energy independence in the near future? with the great bakken shale? please do your research before spewing nonsense. the u.s. has NO chance to be energy independent in the near future. the u.s. consumes 18 million barrels of oil a day and produces 9 million bbl per day. the bakken, at best, may peak at 1 million bbl per day. the decline rate on the bakken wells is horrific. 45 percent a year. and the bakken shale companies need oil at at least 60-70 dollars bbl to survive. if oil goes below that, you now have much of our domestic oil going offline. very disappointing article with no facts to substantiate its wild claims.
  • michael mccreary on November 28 2012 said:
    I see oil falling to new lows this upcoming year. I am short oil and believe it will hit $75 by the end of the march contract. With better fuel efficient vehicles and refiner's along with the abundant supply, oil has nowhere to go up. Sure we will see spikes in prices as traders take action on news events around the world, but the short-long term of 10 to 40 years is domed for oil prices to remain above $50 barrel. When oil runs out and we burn it all up, that is when it goes to zero.
  • Dr. Gary Rutledge on November 28 2012 said:
    I wonder if this goes beyond naivitivity to the point of deliberatly misleading? The author attemps a rosy picture of something of which he has zero knowledge. What is his motive? - other than price/purchasing manipulation?

    Stating: "If world peace breaks out -- a distinct possibility if Iran folds its nuclear program in response to unremitting US pressure --"

    Iran folding its nuclear program is, in fact, /NOT/ a possibility.
    I encourage you to read the public reports of IAEA and
    Institute for Science and International Security (ISIS).

    The trick with oil demand (and panic) will be when, not if, Israel bombs Iran, or worst case, Iran nucs Saudi's primary production areas in the region of Abqaiq.

    IF Saudi supply becomes unavailable to world markets, with the global reserve capacity at about 2Mbbl/day -- The world will see a deficit of 10Mbb/day. Minimum. Does not account for further region unrest and panic.

    There is very little chance of 'peace' in this area.
    Indeed 'peace' would facilitate mid-east regional demand for oil products to climb markedly -- meaning LESS to export.
    The best we can hope for is maintaining an, albeit tense, status quo.

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