Wednesday, December 23, 2015

Post Number 12: The Bottom in Oil

Back on December 14, I wrote:

"It is unrealistic to think that the Saudis and their Gulf allies will give on output without getting something in return. Since it is highly unlikely that the other OPEC members will cut output, this "something" has to be political. It will be tied up with the battles raging in the mideast. When it looks like there may be progress on those, we can start thinking about a firming of oil prices."

That time is now. The politics in the mideast are breaking the Saudis' way, and I believe understandings have been made.

- Iran has substantially cut back its support of the Houthis in Yemen. Apparently they are resigned to let the old Saudi-friendly regime retake control. It's possible that they simply are facing up to the reality that they could not win, but some kind of understanding is also possible.

- A potent anti- ISIS coalition has been formed in Iraq and is forming in Syria. The Iraqi army, the Iranians, the Russians and the US are on the same side, and are coordinating their efforts. This is already getting results in Iraq.

- Turkey looks like it may be getting onboard via closing its border with Syria. If so, there will soon be progress in Syria as well.

- The recent resolution of the UN Security Council on the issue is important. Not because the UN can or will do anything; it cannot. But it shows that the major geopolitical players are united on the importance of settling the issue. This is realpolitics, not symbolism.

So I believe we are at or near (in terms of time) of a bottom in oil. How to play this? I am trading oil futures from the long side. My idea is that there will be a good two-way market for awhile with an upward bias. This is buy the dip tactics. Here are some other ideas for readers who are not active traders.

- Do not buy the usual ETFs like USO or OIL. The contango will kill you. Instead, open a futures account and buy a deferred contract. Dec 2016 or even Dec 2017 are the cleanest ways to play this.

- The equities of E&P companies would also be good. You should be aware however, that these companies are already trading with implied oil prices that are higher than the current strip. So if oil just stays where it is, they could be in serious trouble.

- I would still stay away from natural gas producers. Although NG may get a bounce when the weather turns, there is an ocean of LNG lapping at the shores of the market. This is very bearish for international prices. See my post of December 14 for a little more color.

- The key risk here is that we run out of storage, and the spot price collapses further. If this happens, I do not believe the one or two year forwards will fall too much. They will be dominated by longer term considerations. Nonetheless, they will fall. Either keep this in mind when sizing your position or use appropriate money management techniques.


  1. Hello Burton, You do interesting work, thank you for posting.

    Let me ask you, is there a link between owning a commodity company and the underlying commodity price? ie higher beef prices means Outback stock goes up, (or does Outback just pass on the savings to the customer?)

    I am skeptical of the relationship between a stock and the commodity price.

    Please advise.

  2. Like an idiot I meant to write LOWER BEEF prices get passed on to the Outback customer.

  3. This comment has been removed by the author.

  4. It depends on how competitive the industry is. Restaurants are quite competitive so a change in cost will be passed on the consumers quickly. But it's not so in industries where investments take a long time to mature. Oil is a great example. The reason for the current low price is the high level of investments made over the last ten years. Most of their marginal costs are low, so they continue to be run. Of course the current low prices are reducing investment going forward, sowing the seeds of future high prices. And so it goes.

    1. Thank-you.

      This is what I was referring to:

      In parts 11 and 12, they conclude it is better to own the futures than the commodity producing stock.

      Thanks again, I enjoy your writing.

  5. It's an interesting paper, and got me thinking. They pick as their endpoint 2004, which was close to the high of the commodity cycle. Here's what I mean: I ran a quick backtest of two assets that you can easily buy and hold.
    VTI : Vanguard's exchange traded fund for the entire US stock market
    DBC: Powershares broad-based commodity ETF. This is the oldest commodity ETF I could find.

    Since DBC started at the beginning of 2005, it has lost half its value. VTI's total return has doubled.

    I really question the companies they use to compare to the commodity. For example they use the SIC code for sugar. The companies in that group and sugar refiners, not growers. So it's not a good comparison. They also use the SIC for petroleum refining to compare to crude. That's just crazy.


Comments are welcome, although I can't promise to answer every question.