WHY IS OIL SURGING IN PRICE?

Hang on baby! This sucker is getting crazier by the day. Shortly after Stig and I recorded our podcast on 24 August 2015, I took a 7% portfolio position in oil. Not oil companies, but the commodity. The ticker I used was USO. My average purchase price in the ETF was $14.01, which equated to around $40 per barrel.

After taking this position my gut feeling was that I might be moving too soon and that $35 and $30 oil was in the realm of possible. As luck (which it totally was) would have it, oil jumped to $48 within 1 week after my investment. Yes, it was a 20% return in a week (as of the time of writing), but here’s why I’m concerned in the near term.

So the main reason I liked the USO oil commodity play, was because the long-term price per barrel was no where near $40. I felt that within a 5 year period from the time of purchase, $80 oil was totally in the realm of possible. This was based on the marginal cost to produce (globally) and the expectation that production costs and US dollar devaluation are within a year’s length away. Looking at it from the most simplistic mind-set, I always ask, “What’s my upside versus my down-side?” Well in this case, I felt like $35 was the low (so call that 10% downside in the short term), and $100 was the upside in the long run (call it 120% *assuming it got there in a year). When dealing with a commodity, you don’t have the luxury of earning any income while you hold, so you need to pay close attention to the expected timeline that it might take for the asset to reach that “upside”. For me, I think 5 years was a safe window. Therefore, if it takes 5 years to hit $80 a barrel (just to be more conservative), that would provide a 20% annual return. Now the numbers on all of this are really hypothetical and difficult to predict, but when I looked at other investment opportunities and risks/rewards, this seemed like a really obvious play. In all reality, I could throw out some really crazy numbers on how high oil could go and give some reasonable facts to support the claims, but a 20% annual yield was more than enough to make me a buyer. Enough on why I conducted the purchase, here’s why I’m concerned.

So my opinion is that deflation is slowly starting to take-over. A lot of economists love to leave out the price of oil when they look at inflation figures (because it’s so volatile), but what you can’t do is ignore energy figures over the long term. As I look at the inflation numbers (globally), they continue to struggle. In addition to the lack of inflation, the US hasn’t conducted any more QE and the other countries around the world aren’t printing at the levels the US was in order to push the numbers above 2%. I feel like this deflation is really rearing it’s head in oil. Additionally, I actually believe the FED might raise rates in September or October. I know that sounds crazy, but I think the FED is going to tighten with a .25% federal funds rate increase to “experiment”. If that happens, it should continue to put more deflationary pressures on the world markets. I also believe that if the FED announces a small rate hike, I think China might strategically devalue their currency more. This would only add more strength to the US dollar and downward pressures on US stocks. Now here’s the wrinkle. On Monday 31 AUG 2015, OPEC, Russia, and China announced the intent to have a meeting this week to start normalizing oil prices. As one might expect, this has caused the price of oil to go wild. Here’s the catch, this recent movement is total speculation and front running of higher oil. Although that sounds good for all the struggling oil companies, I guess I’m saying I don’t buy it. Why in the world would the cheapest produces blink first? That makes no sense. Maybe I’m just a conspiracy theorist, but I think nothing is going to come out of this meeting that leads markets to fundamentally see a change in supply and demand deltas in the next two quarters. If I’m right and this meeting is a “farce”, watch out, this $50 price isn’t going to hold. As for my position in USO, I’ll continue to hold while it’s in the green, but I’m watching the price movement very closely. If it passes through my original purchase price, I may even off-load some, or all, of my position. My opinion is that larger market forces are taking over; you know, the forces from a 75 year deleveraging cycle. I think the coming quarters are going to be ugly, so if the pull-back gets severe, oil might get into the 30’s again. To me it doesn’t make any sense that the lowest cost producers would want to potentially give up market share in the final hours of the battle for existence.

-Preston

Update: On 1 SEP 2015, I sold out of all my USO position at approximately $46 on the barrel. I’m still very interested in this play, but I’m waiting for a better time to re-enter the investment.