Let’s take a look at oil. It’s a great “teachable example” of how to understand the mysterious (but understandable) forces behind a market.
After jumping north of $50 following Opec’s decision to limit supply at the backend of 2016, the oil price this year has been largely “range-bound”.
That’s a term that’s vital to Eoin Treacy’s trading strategy. A range develops when there’s no strong reason for prices to rise or fall – so they drift sideways instead. Right now, oil is ranging between $50 and $55.
Ranges can last a long time. They’re a kind of psychological malaise in which expectations and interest deteriorate. But as Eoin constantly tells me, ranges are explosions waiting to happen. When a range breaks out – either up or down – the move can be extreme. Understanding how and why that happens can be extremely profitable. It comes down to behavioural psychology.
Ranges don’t break out by accident. Oil won’t suddenly jump to $60 or $45 without good reason. That means a compelling psychological story or rationale for prices to move sharply up or down, catalysed by an event which triggers the move.
The market is just made up of people after all. People aren’t rational. We often act on instinct and psychological bias. The market is the same. It needs a story to tell itself to justify higher (or lower) prices. Then it needs a trigger – a kick up the arse, frankly – to lend urgency to that story.
This week Eoin has been applying his ideas to the oil market. You can read his full analysis below (by the way, access to Eoin’s trading ideas and alerts usually costs more than £1,000+).
I’ll hand you over to Eoin now.
Best,
Nick O’Connor
Associate Publisher, Capital & Conflict
Oil getting ready to explode
Eoin Treacy
I’m writing this note at 36,000 feet as my plane traverses the North Pole on the way to Dubai. I’m heading to the Middle East to speak at a private leadership conference organised by a renowned billionaire investor for the benefit of himself and his employees. It’s going to be an interesting few days. I’ll be sharing any actionable ideas that come out of it in future issues of Frontier Tech Investor and Trigger Point Trader. However, for now, I want to share my thoughts on the oil market because it is sure to be something I’m asked about when I speak tomorrow.
Crude oil is the largest most liquid (literally), most important and most politically influenced commodity of all. What happens with the oil price affects us all both directly and indirectly. The fact it is characteristically volatile means the dominant argument animating investors and traders can change a lot. It’s a battleground of competing ideas and stories.
The reason I am so keen to write to you about it today is that three very clear stories made headlines on Monday.
The first one I saw was that Saudi Arabia announced to Opec it had cut production by the most in almost a decade. That’s a major achievement, considering the fact it has been pumping record volumes for the last few years and its policy in fact was engineered at achieving the 2014/15 collapse.
The second was that US onshore drilling by shale oil and gas producers is picking up again and volumes are already increasing. One of the ways we can see this graphically is through the futures curve. There is only a $3 spread between oil for delivery in three months and three years. For a commodity, capable of moving that amount in a day, that’s a very tight market.
When the futures curve is so flat, it tells us that the arbitrage to be gained by holding oil in reserve has already been exploited. Suppliers who are economic at between $53 and $57 have been able to lock in profitability for the next three years. With that kind of security, they can now begin to think about investing in new more expensive supply.
That’s all old news, so what’s next?
The one big part of the oil and gas sector that has not taken part in the energy rally over the last 16 months is offshore. First off, it’s more expensive to drill for oil in the middle of the ocean than it is on land and that pushes up the marginal cost of production. Generally speaking, established offshore like the Brent fields in the North Sea or in West African offshore have breakevens somewhere around $40. However, new wells in what might be considered highly probable but still new territory in the Gulf of Mexico are closer to $60 and ultra-deep offshore Brazil is more like $80-$100.
On top of the fact it is more expensive to drill offshore, the Obama administration’s response to the Macondo drilling disaster was to attempt to regulate the offshore drilling sector into irrelevance. It gave sweeping new powers to the US Environmental Protection Agency (EPA) to oversee offshore operations. Together with the collapse in oil prices, that pretty much contributed to offshore drilling coming to a halt. Something I’m waiting for is detail on how the Donald Trump administration is going to defang the EPA because it could be a powerful bullish catalyst for the depressed offshore sector.
All that helps to illustrate how much of a failure the Saudi Arabian policy to increase supply was. It wanted to put US production out of business by crashing oil prices, only to find that it lost the game of chicken and had to blink first. It wanted to drive Canadian heavy oil out of business, but with the North Dakota pipeline just approved and TransCanada reapplying for the Keystone XL pipeline it failed there too. Just FYI: Canada has as much oil as Saudi Arabia, only it’s more expensive to develop and it’s had to sell it at a discount because it is stranded in the middle of nowhere with no pipelines to major refining and/or consuming centres. That’s all going to change in the next decade. North America is going to be energy independent as well as being a major exporter.
The most important thing to remember about this bounteous world we live in is that we never run out of commodities. We just run out of commodities at a given cost of extraction and technology contributes to that cost of extraction contracting all the time. What creates bull markets is when prices have been falling for a long time and a new source of demand appears which takes producers by surprise. Commodity bull markets generally last about 14-17 years because that’s how long it takes to get major new operations off the ground.
We’ve just had a major commodity bull market
It’s over. We can anticipate some major medium-term moves over the next couple of decades, but the year after year of consecutive annual gains in oil prices are over. That’s even before we begin to talk about the long-term threat represented by the march of technology in the energy production, transportation and efficiency sectors which represent major secular headwinds to oil prices.
I got a little sidetracked, but the third thing I wanted to talk to you about is how inert oil prices have been for the last ten weeks. It isn’t just the futures curve; the oil price has gone nowhere since December. The easy prediction is that a big breakout is coming. Every range is an explosion waiting to happen. The hard part is in which direction.
The placid nature of the market right now belies the war between supply and demand that is going on 24/7. Stockmarkets globally are following Wall Street higher on the bet global growth is going to accelerate. That’s bullish for oil because more growth means more demand and higher prices. The question is whether global supply has already increased enough to offset Opec’s supply cut. That’s why markets are ranging. Right now, I’m waiting because there isn’t much to be gained by participating in a $3 range – but I’m ready to buy or sell a breakout because one is definitely coming.
Category: Economics