Investors Belt “How Low Can You Go?” As Oil Does The Limbo

Dear Resource Hunter,

Today I want to take a deeper look at where the oil market is heading – and pinpoint what you need to know.

Back in April, I believed that there would be stubbornly low oil prices for a long time. In particular, I wrote this excerpt for another column:

“Add it all up and what we’re seeing today is a re-writing of the new equilibrium for oil prices. This is uncharted territory – and we’ve got a front row seat.”

Back then my thesis was simple. With U.S. breakeven prices for shale plays closer to $40 (which the mainstream is FINALLY coming around to believe) we’re going to have a tough time breaking above say $65 for a long period of time.

The thesis really is simple. The U.S. is now the world’s “marginal” or “swing” producer of oil. That is, we’ve got decades of U.S. oil under our soil. And when prices are firm enough to turn a decent profit production will swing higher.

From what I’m hearing, the price where producers can make a decent buck is around $60 per barrel, maybe $65. At that price the juice is worth the squeeze for producers.

So the outcome is simple: When the price of oil heads above $60 or $65 in the short-term, U.S. producers will come into the market. These producers will sell their oil forward. These forward contracts, also called hedging, allow companies to look forward a few months and lock in a price that they’ll receive for their oil.

In other words, when oil prices creep up to $60 a barrel, and producers can lock in a profit, they’ll sell.

For example, if it takes a normal pad drilling site, say, 90 days to get from drill bit to production, companies will sell their oil 3-6 months ahead. If they drill in September, they’ll sell forward to January. (Which is all possible via futures/options contracts.)

So what does this mean for oil prices?

Well, as you know the market is nothing more than a bunch of buyers and sellers. And when there are more sellers than buyers, prices drop. From my perch, when oil hits $60-65 per barrel, we’re going to see sellers come out of the woodwork. This ebb and flow will keep the price low until something else changes.

This is the new equilibrium for oil.

Here’s what I said back in April:

“When we see a recovery to, say, $60-65 range, we’re also going to see pressure from shale producers opening up their hedge books.”

We saw our first cycle play out from April to July. Prices tried to break above $60 – and they did for a short time – but, then the sellers took control and prices pulled back.  We’re going to see this same cycle continue to play out over the next 6-12 months (maybe more.)

But there’s more to discuss today…

While we’re on the topic of “lower for longer”

There are other factors at work that continue to pressure oil prices. (I was about to say some more malicious than others – but let’s be honest everything in today’s economic world is malicious.)

First up let’s cover the giant, heavy, sour elephant in the room…

I’m talking about Saudi Arabia.

The Saudis, since November 2014, have done nothing more than run around their sandy castle and open the oil spigots. Today Saudi Arabia is producing 10.45 million barrels per day (mbpd) – up from 10.1 mbpd in July, and up from 9.6 mbpd in November 2014.

It’s overwhelmingly clear that the Saudis are trying to flood the market and drown U.S. shale production — in an attempt to find out the price at which the U.S. shale engine seizes up.

This is another HUGE story in oil.

You see, 10 years ago the Saudis had it easy. They simply got together with their OPEC buddies and kept a lid on oil production – in a monopolized effort to jack up the price of oil.

Those days are over.

Today we’ve got a new game. The Saudis are trying to find out the economics behind U.S. shale (remember, this shale boom caught the Saudis flat footed.) By ramping up production they want to see where the U.S. production will seize up. And I’d assume once they find out (if they find out) they’ll continue to swing their production back and forth in an attempt to gain maximum market share and the highest price.

This may work out for the Saudis, it may not. Right now it’s clear they haven’t broken the back of U.S. shale production. Give this story another six months to play out and we’ll have a better idea.

In the meantime just know that the Saudis don’t care how LOW oil prices go. They’re on a mission to break the shale bonanza. And that’s proving to be a much more difficult (if not impossible) task then they thought.

One more topic on today’s hit parade…

The strength of the U.S. dollar continues.

Love it or hate it, the U.S. dollar is about 18% stronger than it was this time last year.

And just like we’re in a new equilibrium for oil, we may be seeing a new equilibrium for the U.S. dollar. (Man, the past 12 months have really thrown us some curves!)

My point here is simple. As I’ve said in the past the U.S. dollar index is controlled (to the tune of 57%) by the euro currency.

That is, when the euro devalues the U.S. dollar rises.

Well, if you didn’t get the memo last week, the European Central Bank is still intent on continuing its easing and stimulus.

Here’s what the old gray lady had to say: “Euro Falls as ECB’s Draghi Opens Door to More Stimulus.”

The point here is simple: With the euro weakening the U.S. dollar will remain strong. And that inherently puts more pressure on oil prices. After all, oil is priced in U.S. dollars.

Add it all up and we’ve got a one-two punch AND A KICK affecting oil prices.

In the meantime, our “lower for longer” thesis is still intact, that’s for sure.

Keep your boots muddy,

Matt Insley

P.S. Ever wonder how you can make a lot of money from oil without owning a well? Or whether or not you should buy gold and silver? Or is fracking just a flash in the pan? Get insight, insider scoops and actionable investment tips twice a week with Daily Resource Hunter? Just click here for a FREE subscription!

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