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OIL: Looking for the Bottom Part 3

We come now to the last in our series, though by no means the least important. Mainly, we now want to take up environmental concerns, some wildcards, and expand on the banking crisis.

Environment.

I think many traders tend to underestimate the importance of global warming on markets, especially on petromarkets. We’re a hardnosed bunch, and we like to think of ourselves as part of the Rich & Powerful crowd. We aren’t, but it makes us feel good to think so. And the public narrative of the Rich & Powerful has long been that global warming is nonsense- and this gets said right after they say that recent ugly weather phenomena are just ‘natural’, not man-made. To see clearly, the first thing we have to do is shake off that false identification we have with the rich and start seeing what’s really going on with the environment; then we can start looking at what’s being done about it and how that affects oil price. Believe it: The rich know what’s going on with the environment and why, and they don’t like it.

Here’s part of a NOAA (U.S. National Oceanic and Atmospheric Administration) chart ranking global warming by year:

Oil3Bottom1

We can see that, in 135 years, there’s been nothing like the current conditions. Scientists and common sense tell us that it’s directly correlated with industrial growth and- aha- the burning of oil. Then we have little things like the increasing violence of hurricanes and tornadoes, along with rising sea levels and expanding droughts. Maybe we could cope with the hurricanes and tornadoes, but droughts and littoral flooding is another matter. Droughts hit us where it hurts, right in the food basket; littoral (coastline) flooding also hits below the belt, in major economic centers. Droughts produce famines, unrest, and revolutions. Flooding dislocates huge population swathes and can drive Big Insurance (or government) into bankruptcy. Two major stakeholders (worriers) become apparent: governments, and insurance companies. That’s a lot of worry power- quite enough to overcome other Big Money objections to reducing the risk.

Risk reduction comes by way of various clean-energy efforts, like reducing the use of coal, forcing greater efficiency on energy producers and car manufacturers, and encouraging alternative energy development. It isn’t just a fad anymore; it’s policy, and it’s trending hard to the upside. In other words, the move is on to get rid of petrofuels, Big Oil be damned. Besides the Saudis’ other reasons for touching off the global oil price death-spiral, it could well be that they smell the coffee and figure they may as well sell as much as they can while they can, at whatever price.

Inflation Strategy: Save the Banks!

But, since nothing is ever as simple as it seems, we have to expect a backlash against that trend. It’s a curious situation, which in the U.S. places government keenly at odds with itself. Big Oil isn’t as big as Big Banks, but it is a contender. And what Big Oil wants is one last bite at the apple before the world rings down the final curtain on the Fossil Fuel Age. In this bid for a second go, they have an ally in Big Banks, if only temporarily.

An earlier part of this series mentioned the risks to banks of falling oil prices. Banks lent heavily to oil and gas exploration companies in recent years. As of April 2016, aggregate cumulative secured and unsecured debt is around $19 billion, according to the Haynes and Boone Oil Patch Bankruptcy Monitor. And the bankruptcies are only just getting started, with many experts not forecasting a peak before mid-2017. That could put tremendous stress on the banking sector, which in turn could wreck the global economy. It’s therefore in Big Banks’ favor to see a strong oil price rebound. And bear in mind, Big Banks are Wall Street. Government is listening, hoping to thread the needle on this one.

Government’s calculus may be that they can find a way to boost oil prices long enough to save the banks but not so long that they cross the Rubicon on environmental issues and take us all into the abyss. Remember- a price boost encourages more drilling, which means more oil, and the environmental drama gets worse. So what the government can do is use its pseudo-governmental arm the Federal Reserve to monkey with currency values, and to increase the Fed’s balance sheet. Thus the Fed one moment postures as if it’s going to increase rates, thereby strengthening the USD, and then pulls the rug out from under that idea by not following through and instead making dovish cooing noises.

But there’s serious global economic and geopolitical hazard here. By devaluing the USD, the Fed is doing a de facto deflation of other major currencies, creating headaches for countries around the globe. When any country’s currency strengthens (deflation), it reduces their export numbers and reduces internal prices. For some reason, their citizens don’t like doing the same work for less money. This creates serious internal political problems. It can even spark wars of one kind or another. And all that inevitably spells trouble for the U.S. Cleverly, one thinks, the U.S. is trying to tiptoe past these risks with incremental off-and-on Fed moves, just to save the Big Banks who made some bad loans. But will the strategy work? Maybe, at least in part, if only for awhile. I don’t see them forcing $100/bbl again, ever. A flash-run to $50 or even $60/bbl in some crisis might be possible. But, inevitably, all the other factors we’ve mentioned in this series will take their toll on price, driving it back down to $30 or less in short order.

A major technical problem with this strategy to raise oil prices is illustrated in the eight-year baseline-percent chart below, tracking WTI (pink), the dollar index (DX, green), and the E-mini Euro Futures FX index (E7, blue). Note how, in percent terms, the EUR and USD move almost exactly the same amount inverse to each other, i.e., a strong move in the USD results in the same amount of opposite movement in the EUR. Then notice that it takes a much larger move in the USD to even budge WTI. What this means is that for an inflationary strategy on the USD to work in strongly raising oil prices, it will be accompanied by a much stronger deflationary effect on the EUR. Just glancing at the chart, you can see that, in order to bring oil back to $100/bbl with this method would result in the EUR/USD going back up to around 1.4000, a very uncomfortable level for EU states. The diplomatic air would turn blue with recriminations, and no doubt sabotage a great many important statecraft initiatives. Again, from the chart, we can guess that a more likely outcome is that the U.S. settles for $50 oil- at maximum- and lets their banks tread water ’til they find firmer ground.

Oil3Bottom2

The China Card.

Our theory that the Europeans won’t tolerate anything above 1.4000 in the EURUSD exchange rate seems solid. That probably means $50 oil at max. The flip side of this is that the Europeans will likely fight to drive the exchange rate down below its current 1.1367, which would likely force oil down to $30 or less.

China needs oil. The paradox is that higher oil prices desperately need China’s growth, but China needs lower oil prices (near term) in order to halt the slide in its failing economy and generate growth. China is second only to the U.S. in net oil imports, as shown in this U.S. CIA report.

Oil3Bottom3

In fact, recent declines in China’s oil consumption, due to its flagging economy, are largely blamed for the oil crash (though Saudi moves no doubt poured gasoline on the fire). So it’s plain that- for the next couple years, at least- any U.S. strategy to inflate their way out of a looming Big Bank disaster is fraught with difficulties. Without going into a lot of detail, China’s stock market still needs some massive deleveraging, with traders (about 85% of whom are ordinary retail traders) holding their breath in anticipation of further selloffs; there are huge public health problems related to air and water pollution, and intensive capital infusions needed to even start a serious remedy; and, an increasingly restive population has Beijing seriously worried. Bottom line: China must have much lower oil prices, and soon. Rest assured- that’s the goal. It’s a time thing.

The question is, How can China get lower oil prices? One way would be to simply do nothing- just hold their breath and buy less oil. They can handle internal unrest awhile, only coming up for air periodically to buy more oil, then doing the duck-dive and slamming oil price back down. That kind of instability in oil or any market is a sure-fired quant recipe for a crash.

So how low do the Chinese want oil to go? Probably to zero but we all know that won’t happen. And we know that the February 2016 dip to $26 wasn’t deep enough or long enough to solve China’s woes. Their economy continues to slip. A two-year run around $26 might do the trick; or one year at $20 or less.

My final take on playing the China card in looking for a bottom is that you want to look for oil in the $20-23 range at the same time as you’re seeing China’s stock market showing strong growth on a monthly basis. A confirmation would be to also see the EURUSD simultaneously bouncing off the 1.0500 area and durably heading north. With those conditions, we could then have an oil run back into the upper-30s.

Beware Any OPEC Deals

Even as I was writing this, the much-touted Doha OPEC output reduction negotiations faced a sudden and belligerent challenge from Iran’s National Iranian Oil Company (NIOC). It appears that Iran has stoutly opted to pursue market share rather than price, casting a Darth Vaderish shadow over OPEC efforts. The April 8, 2016 Chicago Tribune article said NIOC will sell its “Forozan Blend in May for Asian customers at $2.43 a barrel below the average of the Oman and Dubai benchmark grades” and that NIOC will engage in “vigorous competition” for northwest Europe markets as well.

The timing couldn’t have been better, as it illustrates exactly what I was going to say: Beware media hype about any OPEC or other deals to reduce output. This is going to be a cutthroat fight to the finish. The OPEC hegemony is at an end. Oil-producing nations, large and small, are in dire need of liquidity, and market share is what it takes. I don’t want to pick on just a handful of oil countries, but take a look around at OPEC and non-OPEC producers and you’ll see civil unrest and major economic woes in most of them. By selling enough oil fast enough, they hope to solve some of these problems. Meanwhile, oil-consuming regions have some major business and political constituencies who want oil price to go down- and they’ll likely do what they can to undermine anything like a Doha deal.

Net net: ignore the hype; play the bounce on it if you like, but don’t confuse it with a real bottom. Iran might be a touchstone, though: if you see their prices climbing faster than their competition, we might be on our way.

Stressed Oil Nations’ News: Signs of a Bounce

News reports of major upheavals in key oil-producing nations could signal (temporary) bounces in oil price. Don’t count on it, but such news could move major powers to take steps to force price upwards. I say don’t count on it because it’s a complicated bit of geopolitical calculus requiring a deep knowledge of the aspirations of major players. Here, according to some Bloomberg News data, is a chart from OilPrice.com, showing breakeven price-points for Nigeria, Venezuela, Algeria, Iraq, and Libya (range $122.70-68.80, in that order, and we’re obviously already well below those levels). Full article here. And more detail on likelihood of a further price slide here.

Wildcard: Saudi Solar

I obviously can’t capture the whole Saudi solar story in this short piece, but you should read the full article in the July/August 2015 edition of The Atlantic. It’s lengthy and very nuanced, but I think the essence of it is summed up there with this quote from Saudi royal family member Prince Turki bin Saud bin Mohammad Al Saud: “We have a clear interest in solar energy… And it will soon be expanding exponentially in the kingdom.”

The article goes on to explore some of the challenges to that idea, notably the political delicacy of the task. I’m going to engage in some serious hyperbole here and suggest that, with the right impetus, Saudi Arabia could be supplying solar electric power to the whole of North Africa within a decade. And the “right impetus” is further downward shocks to oil prices. That’s what it would take for solar promoters like Prince Turki to overcome internal opposition to rapid solar expansion.

The Saudis, like nations worldwide, are deeply wedded to the petrofuels pardigm, only their situation is more insidious than others, in the sense that Saudi citizens get lots of major perks from their government (gasoline at $0.50/gal, nearly free electricity, a variety of cash stipends, free care in one of the world’s most advanced healthcare systems, and more), all due to oil production. Within that are lots of private interests who want business as usual. The country consumes about 25% of the oil it produces, with that figure growing at an alarming rate, estimated to make Saudi Arabia a net oil importer by about 2030. So the handwriting is on the wall: to survive, maintain their standard of living, and prevent civil unrest, they must switch to other energy forms, at least for internal use.

The take-away from this section: Even though a solar Saudi Arabia seems a distant mirage, market forces and domestic concerns could accelerate that process in a flash. Right now, the Saudis have the money to do it fast. And remember, smart money around the globe looks to the future, not the present.

Wildcard: Emerging Oil Producers

Uganda’s pipeline extension efforts continue, the latest twist being a route through Tanzania to the Indian Ocean. Tanzania also has its own oil reserves, as do Trinidad and Tobago, among many other nations who don’t make the headlines. Some of these, due to internal stresses, are willing to sell oil at bargain-basement prices for as long as it takes to stabilize their economies. A major issue for all of them is securing investment capital which, with the price decline, is withering steadily. However, with the right kind of deal, they could start pumping in a major way. Chatham House- The Royal Institute of International Affairs, is dedicated to helping them set up regulatory infrastructure and navigate deal-making. They aren’t the biggest producers in the world, but in the aggregate, as they come more online, their impact on oil prices could be significant. So you’ll want to follow their progress with one eye and look for the bottom with the other.

Wildcard: Oil Embargoes?

I was stalled in finishing this Part3 of the series by an idea which should occur to anyone: One way to raise oil prices is to start a war involving a major oil producer. But it stumped me for lack of a credible scenario. Who would fight whom? How would it affect bystander nations? I just couldn’t make it work, aside from the fact that I despise war and hope instead for global peace. Then, last night, CBS News rode to my rescue and provided an alternative to war.

Their April 10, 2016 edition of 60 Minutes resurfaced a dark story which has been brewing for years- the fight to declassify 28 pages of FBI investigations which had been redacted from the 911 Commission report. That the story should be getting fresh press now in so visible a way seemed odd to me. The most recent high-visibility piece I could find on this came from the Aug 7, 2015 edition of the Tampa Bay Times, though there’s probably much more elsewhere. It’s also triggered other news organizations, like the Daily Beast, to revisit the story. Anyway, the long and short of it is that those 28 pages, which insiders say, though it doesn’t amount to actual proof, does nevertheless point a strongly suspicious finger at possible Saudi Arabian government involvement in giving aid and comfort to the 911 attackers.

While the veracity of that notion is so far in the eye of the beholder, it seems possible that release of the 28 pages could stir enough public outrage to provide a pretext for some kind of oil embargo against Saudi Arabia. That would indeed drive oil prices back up and save U.S. banks and their European counterparts, who also have substantial exposure on oil loans, as reported here by Bloomberg News, stating $200 bn in European bank exposure, compared to $123 bn for U.S. banks.

Just another possible wildcard, but one worth watching.

The Wrap-Up.

We’ve covered a tremendous lot of ground here, probably much more than you wanted to know. But the idea was to give you a variety of metrics for finding oil’s bottom and trading it back up. As you’ve seen, I’m pretty pessimistic of any return to oil’s glory days of $100/bbl. My personal ceiling is around $50, and I think that will only be fretful and episodic. Besides all the atmospherics we’ve discussed- and those are important- my main tangible metrics are the M&As, the bankruptcy curve, Credit Bids, and currency moves, all of which were covered here and in other parts of this series.

For a technical and quant view, I’ve developed a variation on the algorithm offered in Part 2 of this series. Like any algo, it isn’t perfect, but seems to work well on the Weekly Brent Light Crude futures contract (/CL) for determining extended upward moves (unlike the swing-trading algo of Part 2). As before, if you want to write your own algo, in MQL or EasyLang or ThinkScript, I provide the narrative form below. I include finished Thinkscript code for it as a companion to my little ThinkScript tutorial at OrangeQuant.com, which can be run even on a free Thinkorswim demo account at TD Ameritrade.

Narrative form: Using FullStochastic, if FullD is greater than FullD of the previous week AT THE SAME TIME as FullK is less than FullK of the previous week, and AT THE SAME TIME as these conditions are met, the Emini Euro FX Futures contract (E7) is greater than E7 of the previous week, a Long signal is created by changing the color of the current bar, typically though not always signaling an extended runup in the /CL contract.

Here’s the resulting chart, accurate enough to be very tradable:

Oil3Bottom4

I hope you found this last of the series at least as useful as the first two, and perhaps even got some gold nuggets of insight into the oil price puzzle.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of FinancialPress.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://financialpress.com/legal-disclaimer/.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of FinancialPress.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://financialpress.com/legal-disclaimer/.

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