Friday, January 2, 2015

My Thoughts on Oil

I actually have written about Oil multiple times, but I don't think I have ever explicitly said what was on my mind.

28 Nov 2014 - Oil On The Streets - Post OPEC meeting, lower demand = over supply
6 Dec 2014 - Schrodinger's Oil is both Good / Bad for the Economy - Lower prices because of lower demand
13 Dec 2014 - Oil's Slippery Slide - Lower for longer will hurt US shale
19 Dec 2014 - Stocks Surge but Oil turmoil? Hmmm.... 1 - 1 = 3? - Demand for Oil is lower, stocks diverging from everything

As of now, Oil is in the $52 handle and I honestly still think that we can go down lower. Why not? Marginal cast costs of production is comfortably in the $30-40 zone. All the rigs and set-up are all sunkcost anyway. Producers are gonna keep running until they are actually losing money to extract the oil, sans investment cost. If we go under $30, I'll eat my hat. Unless the global economy really plunges deep into a depression, I doubt we can see Oil that low.

So, if $40 is about a realistic target to limit downside, why not massively leverage up and long Oil? Downside risks is only about 20% unlevered from here. Well, the fear is lower for longer.

I know that companies hedge out their production. Hedging usually goes out for a few months, 6 months being pretty normal, while 1 year isn't a far stretch. Longer than that, they are just being kiasu. Oil peaked in June, so it has been actually roughly about 6 months since then. As each day and week passes by, more and more Oil companies will slowly be running out of any hedges left, and by end of June 2015, we can really see who can survive in this lower Oil price environment. Between now and then, there are going to be a lot of failures as long as prices are low. That is actually a good thing if you want a price recovery. If nobody is folding at these prices without any hedges, then boy, we are heading for Oil at these prices for a long, long, long time.

The best thing (if you are long Oil) that can happen is between now and end June, all the weakest companies with the shortest hedges and highest costs close down. This cuts off their supply from the market, and hopefully there is enough demand on the other side to soak it up and support prices, or even push them up.

I don't deny that now Oil and related companies are trading very attractively, but this "hedging" factor is impairing my ability to tell for certain if we have bottomed. One of the things that I have done myself is to research previous Oil crashes, and incidentally I found an excellent article about Oil which also included the maximum drawdowns. Exactly what I was looking for!

We are about just over a 50% drawdown, which is the tip of the iceberg. It would be very plausible for us to rally from this level, but then again, the drops are never this swift. Why? Probably because of hedges last time as well. The market needs to see who can survive without any secret backdoor power-ups, and we need at least 6 months for that, but the longer it is, the better it will be when I finally take up positions. It gives more credibility to a stronger base.

The way I eyeball the situation, at a 60% drawdown, that would be a level very delectable for me to start entering positions, and then chasing the guillotine all the way down from there to a 75% drawdown.

So in summary, I think this Oil crash is not over yet. We might get more bounces along the way, but until at least end June, we won't know for sure if these prices can support themselves. We either slowly grind higher as supply meets demand, or we fall off the cliff as supply gets cut to fall down to demand. Between now and then, I feel that pretty much it would be quite speculative to pick up Oil counters.

My other thesis is that lower Oil prices will lead to the failure of the US shale oil, which will massively hurt the US economy. This might be from either just through a normal recession caused by massive unemployment, or a big credit crunch from the collapsing energy sector.

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