Four Reasons Why Oil is Headed For $25 2
silhouettes of oil pumps placed one after another against the sunset

I have learned over the years that there are two subjects you never talk about with people. One is religion and the other is politics. Especially when in a crowded room at a party you’re invited to and you have no idea where other opinions lie. Alas, I must add a third item – oil. I never knew such strong passions could be aroused around black gold. Maybe I should have. I simply thought people could have a rational discussion about the subject, but the problem is that invariably the conversation turns to the politics and religion behind the price of oil.

In June of this year, I wrote an article about oil titled “OPEC and Investing in Oil: Be Prudent and Wait.” The gist of the piece was somewhat contrarian. Many analysts had predicted that when oil broke through $50 a barrel that it would be up, up, and away and we would soon be knocking on the door of $70 oil. I refrained from joining the chorus because I viewed the global economy and the political landscape through an untrained eye and just couldn’t see what the catalyst to make it happen would be. I was right.

Oil is now at about $40 a barrel and even though there has been a slight bump in the last few days, I believe there is nowhere to go but down. Some say $35 while others predict $30, but I am going to go out on a limb and predict $25 a barrel. What makes me confident is a number of factors – call it the perfect storm.

The first and one of the most damaging factors is GDP growth in the United States. Second quarter numbers released a couple of weeks ago shocked everyone as the consensus was that it would be restated upwards to 2.6%, whereas it actually plummeted to 1.2%. Not only that, but the previous quarters were revised downwards as well. I know this is a discussion for another time, but how does an economy, which is coughing, sputtering, and barely keeping its head above water, warrant such low unemployment numbers? Again, to this observer with an untrained eye, it just doesn’t add up.

The second is the confluence of events in the U.S. shale industry. Saudi Arabia essentially went after the U.S. producers with an eye to put them out of business by flooding the market. But there was something they didn’t count on, and that is the resilience of the U.S. oil industry. In a London Daily Telegraph article on July 31, Ambrose Evans-Pritchard pens an article titled, “Texas Shale Oil Has Fought Saudi Arabia To A Standstill.” It sounds like the second coming of the battle of San Jacinto, which lasted all of 18 minutes on April 21, 1836. Mr. Evans-Pritchard begins his article with the opening paragraph, “Opec’s worst fears are coming true. Twenty months after Saudi Arabia took the fateful decision to flood world markets with oil, it has still failed to break the back of the US shale industry.”

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Now back to the resilience of the U.S. producer. Faced with extinction, bankruptcy, and defeat the U.S. shale industry fought back by cutting expenses and “can now produce oil at prices far below levels needed to fund the Saudi welfare state and its military machine, or to cover Opec budget deficits.” Doesn’t that warm the cockles of your heart?

The third reason is because countries like Iran and now Libya are ramping up production and exports which only adds to the global glut. The consensus I’m sure is that their cost to produce the oil is way below the global average, so any revenue they generate from exports will be more than they have now and consequently the glut grows larger. OPEC, and especially Saudi Arabia, are caught in a trap of their own making.

If they were to cut production and the price rises then more and more U.S. shale producers will come back online. In this case, the war they began will end in defeat for them, and the big winner will be global importers and consumers.

The fourth factor has to do with countries like Venezuela, Angola, and Nigeria that are close to bankruptcy. They have had to turn to international lending institutions to stave off what I feel is the inevitable, and that is the total destruction of their economies. Currently, as of July 22, U.S. Shale production is at approximately 8.5 million barrels per day down from a recent high of 9.5 million barrels in May 2016. However, if there is a move upwards in price, created by global political instability, then watch those mothballed rigs come back online. When and if something like that happens, it’s anyone’s guess but in my opinion don’t put your faith in $70 oil anytime soon.

On February 10, 2016 the U.S. Oil Fund (ETF) stood at $7.96 per share. Had an investor ridden that and sold at the top on June 8 they would have made 10.5% (though it has since fallen by about 24%). Even more dramatic is WTI crude which from its low on February 11, 2016 to its high on June 7, was up a whopping 92% but since then has fallen 22%. The current trajectory is certainly downward, and so now is not the time to bottom fish, but to wait on the sidelines – unless you shorted oil back in June, and if you did, congratulations.

Is there money to be made elsewhere then? I would say absolutely and those that come to mind are countries in the developing world that have strong economies with a young population firing on all cylinders. Countries such as India, Vietnam, the Philippines, Taiwan, and Argentina come instinctively to mind. Industry sectors like infrastructure, high tech—especially in India—and real estate will outperform.

So if you are a consumer, enjoy the low cost of gasoline and products made from oil. However, if you are an oil producing economy I believe there is still much pain yet to come before equilibrium is achieved. In my opinion, all the factors listed have not yet converged and when they do, the pain may be excruciating for the developing market economies that rely so heavily on oil for revenue.

Peter Kohli is the CEO of DMS Funds.

This column does not necessarily reflect the opinion of the editorial board or Frontera and its owners. 

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