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Trading Lessons

How Low Can Crude Oil Go?

Commodities / Crude Oil Jan 24, 2009 - 10:18 AM GMT

By: Money_and_Markets

Commodities

Diamond Rated - Best Financial Markets Analysis ArticleSean Brodrick writes: Just a year ago, many people, including me, were bracing for much higher oil prices, and making some good money on energy trades, too. Now, we are seven months into the steepest decline the oil market has ever seen!

Are we near a bottom?


A lot of smart analysts think so …

I get e-mails from people I respect pointing out that the cost of oil is now below the marginal cost of new deepwater oil wells and many Canadian oil sands projects. And all those fancy-pants ideas for getting oil from shale? With oil under $70, you can forget those expensive projects.

Surely, the logic goes, we are going to see a leveling of supply and demand very soon.

While that makes sense, I think we haven't seen the full downside in oil yet. And I think prices could go lower … much lower.

Cheap oil is good news, right? Not in this case. After all, oil is getting cheaper because economic conditions are getting worse .

The good news is you can profit from all this! First, let me lay out some of my reasoning for lower short-term oil prices…

OPEC desperate for cash

Oil for delivery in future months usually costs a few dollars more than near-term delivery. That's called contango. That gap has widened to Grand Canyon proportions — let's call it “super-contango.”

The February crude oil contract, which expired yesterday, traded at $34.25 Tuesday morning before rallying later in the day. At the same time, the July contract traded at $49.78. That's a difference of over $15 — just huge!

This is causing more and more oil storage, as companies try to profit from the super-contango — the disconnect between near-term and further-out oil prices. People are taking delivery, storing it and selling it later.

Two weeks ago , I told you how 25 oil tankers had been turned into floating storage containers holding 50 million barrels of oil. Well, now the amount of oil stored on tankers has risen to a staggering 80 million barrels!

All this stored oil will likely weigh on prices — in other words, we'll have to see it sold into the market before we see a serious oil rally.

The obvious parties that could profit from the oil-storage arbitrage would be oil producing nations. They could just pump less now and “store” oil in the ground. But instead, many Organization of the Petroleum Exporting Countries (OPEC) continue to pump nearly flat-out.

I believe this shows that OPEC producers are desperate for cash and that should keep downward pressure on oil prices. For example, Ecuador recently defaulted on public debts, so it needs all the oil revenue it can get.

Based on projections from the EIA January 2009 Short Term Energy Outlook (STEO), OPEC members could see their net oil export revenues fall to $387 billion in 2009 — down a whopping 60% from the $972 billion earned in 2007.

Only two OPEC members — Saudi Arabia and the United Arab Emirates — have made significant cuts, totaling 400,000 - 450,000 barrels per day (bpd), according to PetroLogistics. Six others, Kuwait, Angola, Libya, Iran, Qatar and Venezuela have made minor cuts. But now, some OPEC members are actually talking about INCREASING production.

Sure, overall OPEC production is going down. But it can't go down fast enough to keep up with demand destruction.

Demand forecasts are falling fast

The U.S. Energy Information Administration lowered its 2009 World Oil Demand Forecast. The EIA says world oil demand will drop by 810,000 barrels per day in 2009 compared with last year, down 200,000 bpd from its December estimate.

Meanwhile, the International Energy Agency is more pessimistic …

The IEA said it expected 2009 global crude demand to contract 0.6% (1 million barrels per day) after dropping 0.3% last year, the first two-year dip in consumption since 1982 and 1983. If the IEA's projections hold true, that would put global crude demand at an average 85.3 million barrels a day this year.

Here in the U.S., we are now importing about 750,000 fewer barrels a day than last year. Yet crude and refined-fuel stockpiles are rising and approaching record highs.

Speaking of stockpiles …

Crude oil, gasoline and distillate inventories continue to rise

Oil storage tanks at Cushing, OK, are almost filled to their limits.
Oil storage tanks at Cushing, OK, are almost filled to their limits.

Last week, crude inventories at Cushing, OK, the delivery point for crude futures traded on the New York Mercantile Exchange, rose 2.5% (1.2 million barrels) to 33 million barrels, up 20% in four weeks. The inventory level is approaching Cushing's operable storage capacity of about 34 million barrels, as estimated by Platts.

Moreover, this demand crunch could continue for some time

We're probably going to see an economic crunch for quite some time. Not only here in the U.S., but all over the world. Europe, Japan, and many emerging markets all seem headed toward a hard landing.

Something that really illustrates this is the thousands of cars that are being abandoned at Dubai airports by immigrant workers who have hit dead-ends. Most of the cars are left with the keys in the ignition, as the Dubai bubble bursts.

Speaking of abandoned cars, the Guardian in London recently published a photo essay illustrating how carmakers around the world are groaning as inventories build up to unprecedented levels. Storage areas and docksides are now packed with vast expanses of unsold cars as demand slumps.

Does that sound good for the global economy or oil consumption?

Hardly.

In fact, it's pretty clear that the decline in demand is outpacing the decline in net oil exports. And that is going to keep downward pressure on prices.

Oil Could Plunge Below $20 Before Hitting Bottom …

If oil closes below $33, I think it could go to $25. And if oil gets to $25, sheer momentum could carry it to $20. And if it gets to $20, then it could even test its long-term support — just above $17 — before finding a bottom.

Monthly chart shows that crude oil continues to break support.

So is the oil bubble over? Maybe, but you better brace yourself for Oil Bubble II.

Why We'll See Oil Prices Surge Again

The fall in crude oil prices is wreaking havoc in oil services and oil drilling. Now, projects and new rigs are being canceled. And that means the flow from new wells won't be there when we need it later.

The number of rigs actively exploring for oil and natural gas in the United States dropped by 21 last week to 1,568. A year ago, the rig count stood at 1,732.

Existing oil wells are slowly being depleted.

Just look at Mexico. Our #3 supplier of imported oil will likely report that its oil production fell 9% last year alone. And production from Mexico's super-giant Cantarell field will probably fall even faster this year.

With prices so low, not enough new wells are coming online to be in place when oil demand goes higher again. And that means the gap between what we in the U.S. consume and what we produce is about to get even wider …

USA crude oil production and consumption.

Source: europe.theoildrum.com

And that means America will be even more vulnerable to an interruption of imported oil.

According to analysts at Macquarie, even if oil prices recover to between $70 and $90 over the next three to five years, any increase in exploration and production budgets will be slow and spread out.

How about President Obama's plan to get us off imported oil? Oh, I think we'll get to those projects eventually. It's just hard to make the case for expensive alternative fuels when oil is below $50 a barrel.

Enjoy the low oil prices while you can. They're not going to last long.
Enjoy the low oil prices while you can. They're not going to last long.

So, enjoy the low oil prices. They will end, and perhaps even sooner rather than later. It wouldn't surprise me to see $75 oil later this year as more projects are shut in.

So What Can You Buy To Ride This Wild Market?

I have two ways to play this wild market that you may want to consider:

Oil Play#1
The PowerShares DB Crude Oil Double Short ETN (DTO) is designed to track twice the inverse of oil's daily movements. In other words, the ETF could go up 20% for each 10% drop in crude prices. However, be aware that, in this volatile market, oil could rally to 45 or so before heading lower again. And the ETF's shares could fall 20% for each 10% rise in crude prices.

Oil Play #2
Great oil companies on the cheap. That's right, even though I think oil prices are going lower in the short term, I consider this a great time to buy good oil stocks for the long term. Why? Because I'd rather buy stocks of excellent companies when prices are low rather than when prices are high.

The kind of stocks I'm talking about have plenty of cash and the potential to expand their reserves. Cash-rich drillers and well-positioned explorers should also be in the bargain bin. In fact, I expect I may find some of these companies — these diamonds in the dustbin — when I go to Vancouver in just a few short days.

So stay tuned!

Yours for trading profits,

Sean

P.S. In just a few days, I'm heading up to British Columbia to attend the Vancouver Resource Investment Conference. I've also arranged to meet with some of the most promising small-cap natural resource companies in Canada … and the world.

Along with the best energy companies you never heard of, I'm looking for smaller gold and silver miners that are off the radar screen and that are in, or near, production. I'm talking about companies with pounds in the ground — or even with production — that are way undervalued compared to bigger companies.

And on January 29, I will fire off a special report with my recommendations for my three best picks in Canadian small-caps right now.

These stocks are too small for a recommendation in Money and Markets . So this report will only be available to a select, elite group of subscribers … subscribers to my Red-Hot Global Small-Caps .

If you want to get in on the ground floor of three of tomorrow's superstars, call 1-800-898-0819 or click here . And my team will make sure you're all squared away so you can act on these recommendations IMMEDIATELY as soon as my report comes out!

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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