9 Reasons Why Oil Prices May Be Headed For A Bust

Though the U.S. shale oil boom of the past several years has led to a renewed surge of domestic oil production as well as an oil glut, crude oil prices have remained stubbornly high. There are a growing number of reasons, however, why crude oil prices are likely to finally experience a bust in the not-too-distant future. I avoid making firm predictions about the oil market because there are so many conflicting variables that affect oil prices, from supply and demand, geopolitics (which is inherently unpredictable), and the global monetary environment, but it is important to be aware of several factors that have a high probability of pushing crude oil prices lower in the next couple of years.

1) The unwinding of record speculative bullish bets

To prop up the global economy after the 2008 financial crisis, global central banks dramatically cut interest rates and printed trillions of dollars worth of new currency via quantitative easing programs. Extremely stimulative monetary environments increase the desirability of hard assets such as oil and other commodities because they are a hedge against currency debasement and the associated risk of inflation.

For the past half-decade, institutional investors have clamored into the crude oil market, causing prices to soar 140 percent from their post-financial crisis lows. The chart below shows that large crude oil futures speculators (green line under chart) are currently making a record bet of 423,136 net contracts on the continued appreciation of oil prices:

^{Chart source: Barchart.com}

The data that I am citing comes from the U.S. Commodity Futures Trading Commission’s weekly Commitments of Traders (COT) report that shows the aggregate number of futures and options contracts that are held by three different categories of futures market participants: large speculators, small speculators, and commercial hedgers.

Large speculators – the group that is placing the record bullish crude oil bet – are typically investment funds that trade in a trend-following manner, which means that they tend to capture the middle part of market moves, but are often wrong at important market turning points. The nature of the large speculators’ trend following trading systems cause them, as a group, to bet most aggressively right before the trend reverses. As the old Wall Street adage goes, “when everybody gets to one side of the boat, it usually tips over.” For this reason, large speculators become an effective contrary indicator when their aggregate trading positions reach extreme levels, either on the upside or the downside.

While extreme aggregate trading positions can persist for quite a while, as is the case in the crude oil market for the past few years, they are still a reliable indication that a powerful market reversal is likely to occur when the proper catalyst eventually appears and sends speculators heading for the exits. So far, no bearish catalyst has presented itself in the crude oil market, but the other points that I’ve listed in this piece may combine to form a perfect storm that finally causes the oil market to crack.

2) The “smart money” is growing increasingly bearish

In the futures market, there is a buyer for every seller, and a bull for every bear (on a contract-by-contract basis). For every futures contract currently being held by bullish large speculators in the oil market, there is someone on the opposite side of the trade. In the current crude oil market, it is the commercial hedgers that are taking the exact opposite position as the large speculators:

Commercial hedgers are the actual producers and users of crude oil (the Exxons and BPs) who utilize the futures market as a form of insurance against adverse price moves. Commercial hedgers are considered to be the “smart money” because, after all, they are the physical crude oil market and have firsthand information about future supply and demand trends.

Commercial hedgers now have a record 445,492 net contract short position in the crude oil futures market, which indicates that their greatest concern is not an increase in crude oil prices, but a sharp decline. Commercial crude oil hedgers are aware of many of the bearish points that I am discussing in this article, which likely explains why they are heavily hedging against a coming crude oil bust.

3) The global monetary environment is tightening

As discussed in point #1, the crude oil price boom of the past half-decade is due in large part to the incredibly stimulative monetary environment that has been created by central banks in a desperate attempt to prop up global economy after the financial crisis. Now that unemployment is falling and the risk of an imminent deflationary crisis has been reduced in the U.S. and U.K. (two major countries that are running QE “money printing” programs), the current global economic cycle is moving into a phase in which stimulative central bank policies will be gradually pared back and eventually reversed.

The U.S. Federal Reserve is expected to complete the tapering or ending of its QE3 program by the end of 2014, while the Fed Funds Rate is expected to start rising as early as 2015. Similarly, Bank of Japan is now preparing for the eventual ending of its Abenomics monetary policy now that it is much closer to achieving its 2 percent inflation target. Bank of England is considering plans to start raising interest rates in the coming years as well, which is a precursor to the tapering of its QE policy.

The European Central Bank, however, is bucking the monetary tightening trend after cutting its benchmark interest rate last week by 10 basis points to 0.15 percent and introducing a deposit interest rate of negative 0.10 percent. The ECB is also considering launching its own quantitative easing program in the future. Unlike the U.S. Federal Reserve’s QE programs, a European QE is not likely to be as supportive for crude oil prices because even mere rumors regarding it have weakened the euro and boosted the U.S. dollar in the past month, which has put downward pressure on commodities prices. Many commodities, including oil, are priced in U.S. dollars, so central bank policies that are bullish for the dollar are typically bearish for commodities prices. The simultaneous tightening of U.S. monetary policy and the loosening of European monetary policy could set the stage for a powerful bull market in the U.S. dollar.

The U.S. Federal Reserve’s policies are by far the most important monetary variable for crude oil prices, so its tightening over the next few years represents the ending of one of the key driving forces behind crude oil’s bull market of the past half-decade. In addition, the massive inflation and imminent currency devaluation that many commodities traders had expected to occur as a result of quantitative easing programs has not materialized and is unlikely to in the near future.

4) The shale oil boom is increasing supply

Surging North American oil production, courtesy of the recent U.S. shale and Canadian oil sand booms, is dramatically reducing U.S. oil imports and has even led to a glut of light, sweet crude oil in the United States.

In the past five years, U.S. oil production experienced a sharp reversal of its long-term downtrend and recently hit a twenty-five year high:

^{Source: U.S. Global Investors}

Net U.S. oil imports fell to a 28-year low in 2013 as a result of the shale oil boom:

^{Source: Mark J. Perry}

U.S. oil production is expected to grow to 9.2 million barrels a day in 2015 and 9.6 million by 2016, which would make the U.S. the world’s largest oil producer, ahead of even Saudi Arabia and Russia. Canada’s oil sand boom is expected to boost the country’s oil production by 500,000 barrels per day to achieve a total production of 3.9 million barrels per day in 2015, much of which will be exported to the United States.

As the world largest oil consumer, the United States’ oil boom has significantly decreased the country’s reliance on foreign sources of oil, particularly from the volatile Middle East. This is one of the main reasons why global oil prices have remained relatively flat for the past several years despite the Arab Spring revolutions that led to an 80 percent decrease of Libyan oil production and other disruptions, as well Russia’s recent invasion of eastern Ukraine. According to oil analyst Lysle Brinker, oil prices may have soared to as high as $150 a barrel without the increase of U.S. oil production.

A glut of light, sweet crude oil is even forming in the United States as a result of rising domestic oil production as well as the U.S. crude oil export ban that dates back to 1975. Oil companies and oil-producing states such as Texas and North Dakota are pushing to have the export ban lifted so that the U.S. can export some of its newfound energy bounty to the global oil market. While shale oil deposits are found throughout the world, other countries face greater difficulties in their attempts to replicate the U.S. oil shale boom.

The same technologies that have enabled the oil shale boom – fracking and horizontal drilling – have also led to a nearly 40 percent increase in U.S. natural gas production since 2007. Now one of the lowest cost fuels, natural gas is expected to further reduce the United States’ reliance on oil, particularly for electricity generation, heating, chemical manufacturing, and even transportation.

The high price of oil in the past decade has been a major driving force behind the U.S. shale energy boom because it enabled the use of new drilling technologies that would not have been economically viable at lower prices. The continuation of the U.S. shale energy boom in the next few years is likely to put pressure on crude oil prices in accordance with the principle, “the only cure for high prices is high prices.”

5) Production is starting up again in many countries 

Oil production and exports are poised to begin again in many countries that experienced severe disruptions in recent years:

Iran: After Western economic sanctions were placed on Iran due to its nuclear program caused a near-collapse of its economy and currency in 2012, the nation appears ready to strike a deal so that it can export its oil to the West again. Oppenheimer oil analyst Fadel Gheit claims that the Iran-related “supply risk premium” accounts for 20-30 percent of the price of oil, which would disappear and send prices to the $75-$85 range once a deal is finally struck with the West. 1 million more barrels of oil per day could enter the market when Iran’s nuclear issue is resolved.

Iraq: Iraq’s oil production recently hit a 30-year high as its oil industry rebuilds after the war and decades of underinvestment. Iraq has the world’s fifth-largest proven oil reserves, and several hundred thousand more barrels of oil per day are expected to come online this year alone.

Libya: Libya’s oil production plunged by over 80 percent from 1.6 million barrels a day to just 237,000 barrels a day after the country’s revolution in 2011. While Libya’s oil situation remains volatile due to protests that have shut down pipelines and ports, an eventual resolution could double production to 500,000 barrels a day.

Venezuela: Despite numerous political challenges that have reduced Venezuela’s oil production in the past decade, Leo Drollas, the head of the Centre for Global Energy Studies, expects 250,000 more barrels of oil per day to come online this year. European energy companies Eni SpA and Repsol SA have signed deals last week to invest up to $500 million each to develop Venezuela’s Perla oil field, which is considered to be one of the most important discoveries of the past decade.

6) OPEC’s limited ability to boost prices by cutting production

When oil prices dropped significantly in the past, OPEC countries would cut their oil production to bolster the price of oil. Growing fiscal deficits in many OPEC nations in recent years, however, make it far more difficult to cut oil production because these countries can no longer afford the loss of oil revenues.

7) Global oil demand is slowing

Led by China and other emerging nations, global oil demand spiked in the years following the 2008 financial crisis, which contributed to oil’s bull market. Since 2011, oil demand growth has slowed significantly to a half-decade low largely due to the ongoing economic slowdown in China and emerging economies:

^{Source: Dr. Ed Yardeni}

8) The global economic “recovery” is actually another bubble

As discussed in the last point, oil demand and prices are highly dependent on global economic growth. The financial crisis and subsequent Great Recession was what popped the 2008 oil bubble after prices reached nearly $150 per barrel. After the price of oil sank in late-2008, the post-2009 economic recovery helped oil prices to rise 140 percent from their financial crisis low.

Unfortunately, my extensive research has found that the global economic recovery that has driven oil prices higher is actually an artificial, bubble-driven recovery that I call a “Bubblecovery.” In a desperate attempt to prevent a deflationary depression, central banks pumped trillions of dollars worth of liquidity into the global financial system and cut interest rates to virtually zero percent. In short order, new economic bubbles started ballooning in China, emerging markets, Canada, Australia, Nordic countries, commodities, tech startups, and U.S. equities and housing prices, to name a few (read my Bubblecovery article for more information). Property and credit bubbles are inflating once again all around the world in a pattern that is very similar to the last decade’s bubble that caused the financial crisis in the first place.

This chart shows that Canada’s housing and household debt bubble is even worse than the U.S.’ bubble last decade:

^{Source: Maclean’s}

These days, it makes no difference whether you look at the charts of property prices and debt in Canada, or in Australia, Norway, Hong Kong, China, or Singapore; the charts all look the same and show the same classic bubble pattern. The world is caught up in an epidemic of post-2009 bubbles, but the vast majority of people are completely unaware and in denial.

Here are a few terrifying statistics that show how dangerous China’s economic bubble is:

• China’s total domestic credit more than doubled to $23 trillion from $9 trillion in 2008, which is equivalent to adding the entire U.S. commercial banking sector.
• Borrowing has risen as a share of China’s national income to more than 200 percent, from 135 percent in 2008.
• China’s credit growth rate is now faster than Japan’s before its 1990 bust and America’s before 2008, with half of that growth in the shadow-banking sector.

The post-2009 economic bubbles are the primary reason why the global economy started growing again because bubbles create temporary growth booms before ending in crises. When the post-2009 bubbles pop, global economic growth is going to sink (and there will not be a quick recovery like last time), which will reduce demand for oil.

9) The ending of the commodities supercycle

As I mentioned in the last point, commodities are one of the key bubbles that I have identified. Artificial, debt-driven economic growth in China and other emerging market nations combined with the unprecedented ocean of central bank liquidity caused commodities prices to triple since 2002:

^{Source: Barchart.com}

Hundreds of billions of dollars worth of investment capital clamored into commodities as investors began to treat commodities as a new long-term asset class, similar to equities and bonds. Many of these investors also viewed commodities as a way to play the China and emerging markets boom.

Record high commodities prices spurred a massive global exploration and extraction boom that is now leading to growing gluts in numerous commodities, particularly growth-sensitive commodities like copper and iron ore, as rising supply is met with slowing demand from China and emerging markets. As stated earlier, “the only cure for high prices is high prices.” When the post-2009 global economic bubble pops, I believe that commodities prices will finally experience a true bust.

A Tactical Take On Crude Oil

Crude oil is one of the hardest markets to predict by far because there are so many conflicting crosscurrents that affect its price including supply and demand, geopolitics, and the global monetary and regulatory environment. In many ways, analyzing the crude oil market is very much like playing three-dimensional chess. Though I have listed numerous fundamental reasons why a correction is likely to occur in the crude oil market, it is important to be aware of some of the potential upside risks that may override these bearish factors in the shorter-term:

• Geopolitical risks such as an escalation of the Russia-Ukraine situation, a flare-up in the Middle East, a worsening of the political crises in Venezuela or Libya, etc.
• The risk that inflation picks up significantly in major developed economies like the U.S. as the “Bubblecovery” or bubble-driven economic recovery matures.
• A significant, unexpected economic slowdown in the U.S. causes the Fed to step on the monetary accelerator again by abandoning or reversing the QE taper.
• A large-scale downward revision of estimated U.S. shale oil reserves causes a buying panic. In this scenario, I am questioning whether the recent 96 percent downward revision of estimated recoverable shale oil in California’s Monterey Shale formation is an isolated case or if it may occur on a larger scale across the country.

The potentially bearish factors that I have listed in this article tend to have more relevance for the intermediate-term future (within the next few years) of crude oil prices rather than the short-term or long-term future. For shorter-term or tactical market decisions, I rely less on fundamental analysis and more on technical analysis or analysis of price and momentum trends.

There are two primary futures contracts that are used as global crude oil price benchmarks: West Texas Intermediate (WTI) Light Sweet Crude Oil, which is the main benchmark in the U.S., and Brent Crude Oil, which better reflects the crude oil market outside of the U.S.

WTI crude has remained within a relatively narrow trading range between the $80 support level and the $110-$115 resistance zone since the start of 2011. There is also a rising support line that began at the crude oil market’s early-2009 low. A break above the $110-$115 resistance zone would trigger an important “buy” signal, and I certainly would not be shorting oil in that scenario. A break below the rising support line and $80 support level, however, would trigger an important “sell” signal, which would likely be the confirmation that an oil bust has finally begun.

^{Source: Barchart.com}

 

Similar to WTI crude, Brent Crude has been in a trading range between the $90-$100 support zone and $125 resistance level. A break above the $125 resistance level would indicate that further bullish action is likely, while a break below the $90-$100 support zone would be an important bearish confirmation signal.

^{Source: Barchart.com}

I believe in always having an exit strategy or stop loss order when trading technical breakouts in case the market abruptly reverses and “head fakes” traders who are playing the breakout. For example, if crude oil dropped below its key support levels and I decided to place a short trade, but the market reverses and manages to break back above the former support level, I would simply exit my short position with a small loss.

A Long-Term Take On Crude Oil

Now that I have outlined my shorter and intermediate-term outlook for crude oil, it is time to discuss my long-term outlook. I have a more constructive outlook on oil prices in the longer-term than I do in the intermediate-term future.

Despite the optimism that many people have about the shale energy boom, I believe that it only slightly delays the ending of the “cheap oil” era and that Peak Oil theorists will still be right in the longer run. While a crude oil correction is likely to occur within the next few years, I do not expect oil prices to remain at low levels for a very long time. The energy returned on energy invested or ERoEI for shale oil is far lower than for conventional oil, which is evidence that cheap oil is becoming much more scarce even though overall U.S. oil production has increased.

I am also growing increasingly concerned that the U.S. shale energy boom is actually another post-2009 economic bubble (it would be a part of the commodities bubble). In a zero-percent interest rate environment like we are currently experiencing, any economic boom can devolve into a bubble. Shale energy extraction is a very capital-intensive business that relies heavily on cheap credit to survive. Shale oil wells experience much faster decline rates than conventional oil wells, which means that energy companies must keep drilling at a furious pace just to maintain their production – a very costly proposition that is typically funded by copious amounts of debt.

In addition to cheap credit, the shale oil boom’s entire existence is predicated on today’s relatively high oil prices. If the price of oil dropped below $70-$80 per barrel, many shale energy companies would fail in a short amount of time as the industry experiences a bust, and investors and lenders would sour on shale energy after taking serious losses. Ironically, this shale energy bust scenario would ultimately lead to even higher oil prices in the longer run after the world realizes that shale energy doesn’t quite live up to its hype.

The eventual devaluation of many fiat or “paper” currencies is another factor that will likely lead to much higher crude oil prices in the long run. The popping of the post-2009 economic bubbles will be met with even more aggressive monetary easing or “money printing”, which is likely to push the global monetary system to a breaking point in which currencies like the U.S. dollar and Japanese yen sink even further in value. In this scenario, global capital would flee away from paper assets like currencies, stocks, and bonds, and into safe-haven commodities such as precious metals, oil, and agricultural commodities, sending their prices soaring as they become permanently revalued in fiat currency terms. I foresee a permanent transfer of wealth from those who own paper assets to those who own the aforementioned hard assets.

Conclusion

To summarize, there are a growing number of risks that make an oil price correction likely within the next few years, but long-term oil prices should remain high as cheap oil sources dwindle and fiat currencies are relentlessly debased in an attempt to prop up the bubble and debt-ridden global economy. Investors can take advantage of a possible coming oil slump to position themselves ahead of the next phase of the bull market in oil.

I am publishing many reports about dangerous bubbles that are currently developing around the entire world – most of which you probably never even knew existed.

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