When Crude Oil Slips… Buy the Dips

By Eric Fry
Contributor

Oil & Gas

The oil market was probably overdue for a smackdown, and it finally arrived. After hitting a three-year high above $72 a barrel last week, the price of WTI crude tumbled below $67 this week.

Russia gets the blame… again.

According to various news reports, the Russians and Saudis hinted they might boost oil production by 1 million barrels per day (bpd) – thereby ending a production freeze they helped put into place at the end of 2016.

Immediately after this story broke, the oil price tanked. And now investors are asking that age-old question: What next?

Does the oil market’s swift retreat signal the end of its yearlong rally? Or is this sell-off merely the pause that refreshes it?

The latter of these two possibilities seems like the better bet.

Obviously, the possibility that oil production might soon increase is unwelcome news to investors in oil-related investments. But the proposed Russia-Saudi output boost might not actually boost output at all. It might only replace production the world has lost already – or might soon lose.

Venezuelan oil production is in distress and falling sharply. The Platts OPEC Survey recently stated that Venezuela’s output has plummeted by more than half a million bpd during the last 12 months – hitting the country’s lowest production levels of the last three decades.

According to most estimates, Venezuela is still producing about 1.5 million bpd. But that number is falling month after month and shows no sign of stabilizing. So it would not be a surprise if the country’s production dropped by another half a million bpd during the next 12 months.

In other words, Venezuela’s oil output is on track to fall by 1 million bpd from its 2017 levels.

That would mean that the additional 1 million barrels that might come from Russia and Saudi Arabia would not be additional on a net basis… It would simply replace what is lost elsewhere.

Beyond Venezuela, another big wild card could remove some crude supplies from the market: Iran.

As the world’s fifth-largest oil producer, Iran currently pumps about 3.8 million bpd. But due to new U.S. sanctions, Iran’s oil exports could drop significantly.

Some analysts predict the country’s oil exports will fall as much as 500,000 bpd. Others predict they won’t fall at all.

These informed guesses are just that: guesses. No one knows because no one can effectively handicap a geopolitical spat between two equally stubborn parties.

That’s why this situation is truly a wild card.

Meanwhile, on the demand side of the oil market, the trend line marches higher and higher. Based on data from the U.S. Department of Energy (DOE), global demand overtook global production early last year and has been flying higher ever since.

Here in the U.S., for example, crude demand recently hit 20 million bpd, the highest level in a decade, according to the DOE. That’s a big part of the reason domestic crude inventories have been falling.

The chart below shows the level of U.S. crude oil inventories, expressed as days’ worth of U.S. consumption. One year ago, this reading topped 27 days of consumption – the highest level of the last three decades…

But at the start of this year, that reading had dropped below 22 days, which is below the three-year average inventory level. In other words, the U.S. is no longer drowning in oceans of excess crude oil.

Internationally, a similar trend is underway. Rising demand for oil is sucking up supply. China’s oil demand, for example, continues to be very robust. Imports have jumped more than 20% during the last two years…

As a result of trends like these, global oil demand continues to outpace global oil production. That’s a very favorable omen for oil prices…

The chart above shows global demand expressed as a percentage above or below global oil production. In early 2015, for example, global demand was about 1.5% below global production, according to the DOE. Today, however, demand is running about 0.6% above production, according to the DOE.

A nearly identical trend unfolded between 2004 and 2008, and the oil price soared from $32 a barrel to $147, according to Bloomberg.

Today’s oil price might not soar 350% like it did back then, but it is likely to continue moving higher.

Already, during the current bullish episode, the price of crude has climbed from a low of $26 a barrel in early 2016 to $72 last week.

Next stop, $100 a barrel!

Good investing,

Eric