Black Gold Is in a Bear Market Rally, Nothing More

A few weeks back I mentioned an article a colleague of mine wrote about the Saudi-engineered deal to have OPEC member nations — as well as some major non-OPEC suppliers — cut production. They wanted to raise oil to around $60 a barrel.

My friend, who has made his career being a keen observer of the energy patch for decades, was very wary of the deal.

His is a contrarian view of the sector and almost everyone is on the other side. Investors are believing the hype that Wall Street is more than happy to provide.

The danger with being contrarian right now in the oil patch is, no one is on the fence about prices (they’re all bullish) and few see a downward path for oil.

Well, over the Christmas holidays, I saw an interesting interview in Barron’s. They were asking T. Rowe Price New Era Fund manager Shawn Driscoll about his take on the current rally in oil.

Now, bear in mind, T. Rowe Price is in Baltimore, not New York City. It is a self-contained, investor and institutional-focused business. That means T. Rowe manages a lot of 401(k) and pension money. It’s not a flashy player.

But it is a smart player. T Rowe Price was one of the few big investment firms that saw trouble in the real estate sector in 2006 and started to divest of any sketchy securities tied to the sub-prime mortgage craze.

T. Rowe relies on its own research and it doesn’t have the constant ‘me-too’ chatter that the firms on Wall Street constantly engage in. T Rowe does its work and keeps its research to itself… unless asked.

And Driscoll’s record is cut from that same cloth. He saw what was happening in the energy sector, in commodities in general, and began positioning for a crash starting in early 2014.

Driscoll sees the oil patch similarly to the way my colleague Elliott Gue does. They both feel this run-up in oil prices is not as durable as it seems. Driscoll believes it to be a bear market rally similar to oil bear markets of the 1980s and ‘90s — except worse.

And now, OPEC no longer has the stranglehold on oil supplies as it once did. More development outside the oil cartel — U.S., Russia, Africa, South America, etc. — are changing this market forever.

There are major finds off of Brazil that have yet to be developed. The U.S. fracking and exploration & production (E&P) sector is back in action, largely because the companies needed to get some cash flow to pay the banks for all the lines of credit and loans the banks shelled out at the top of the market. In West Africa production is growing after several months of troubles.

The point is, there are many suppliers coming back on line right now and that is going to change the amount of control OPEC has over the oil markets. And at current prices, even U.S. E&Ps are making good money.

Remember Saudi Arabia has one of the lowest cost of production in the world — total cost of production is around $31 a barrel for the best grade oil (light sweet crude) and even cheaper for lesser grades. U.S. have to spend a lot more to extract and process oil, and firms are lucky if they turn a profit below $50 barrel.

And I, like Driscoll, foresee a reckoning for oil prices after the first part of 2017. You may not see prices sink into the $20 a barrel range, but low to mid-$40s would be a sustainable level. This will also force out weaker players, and bigger players will eat the weak.

Also OPEC’s production cut only lasts until summer starts in the Middle East, when air conditioning gets kicked on in earnest and energy is in very high demand. The Saudi royal family is in a very difficult situation with its population, so cheap AC would mean pulling the plug on the promised production cuts.

That said, the analysts on the bullish side are pricing in $60 or $70 a barrel oil. This kind of discrepancy leads to big market moves in both commodities and stocks when they’re proven wrong.

This will also be after President Trump has moved into the office and we see the difference between his tweeting and his governing.

If you’re not wearing petrol-covered glasses, most common sense and facts point to a short-lived bear rally in oil, followed early next year by a price correction as new supplies come online.

Don’t follow the trend here. Avoid getting involved investing in oil because you think it’s on the way up.

— GS Early

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