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Has Oil Hit Bottom?

22 October 2014 in Trading Ideas

There’s nothing like a dip in global economic expectations to put a serious crimp in commodity prices – and oil often leads the way.

Over the past four months, the price of light crude has plunged by about 25%, currently hovering around $80 a barrel at levels not seen in more than two years.

Unsurprisingly, this period hasn’t represented the best time for oil and gas-related equities. The Shale Oil motif, for example, has fallen 26.1% in the past three months. During that same time period, the S&P 500 has lost 2.9%.

The Shale Gas motif is down 20.4% in the past three months.

For the year to date, the Shale Oil motif has decreased 7.5%, while the Shale Gas motif is down 17.9%. The S&P 500 is up 5.4% in 2014.

Since the price of oil is essentially sitting at the point from which it bounced two years ago, the question becomes: Is the price of oil poised to climb from here?

In the latest Barron’s, Thomas Streater suggests that – eventually — it is. Streater wrote that one factor causing oil to slump has been a stronger US dollar, which has been lifted by expectations of a tighter US monetary policy. Next, the IMF downgraded 2014 global growth projections to 3.3% from 3.7%, and lowered its projection for 2015 growth to 3.8% from 4%.1

On top of that, the International Energy Agency last week also reduced its own expectations for oil demand growth in 2014 and 2015, Streater noted.

But according to Streater, a fall of 13% in oil prices in one month isn’t in line with the real rate of change in the oil supply-and-demand balance. Streater cites a recent Goldman Sachs note that declares that this final drop in oil was likely caused by technical reasons driven by dealer hedging of option positions.

Goldman also reminded investors that unlike financial assets, commodities are spot assets clearing today’s supply and demand and that “the supply glut is not yet here today, it exists in expectations”. This means, Streater said, that any pessimism about future market supply should not be reflected by such a low spot price today.

Meanwhile, Streater said that Sanford C. Bernstein has declared a longer-term view that oil should generally trade around the marginal cost of production, which they estimate to be around $100 a barrel. On the supply front, Bernstein believes that US oil supply growth is gradually slowing and Russian production is declining. Despite suggestions that leading OPEC nations won’t cut output, Bernstein says they likely will to support prices.

Likewise, Bernstein notes that while China’s slowing growth has hurt demand for oil products like diesel, which is heavily used in industry, oil prices will be supported in the long term by increased consumption of transportation fuels as car ownership rises in China. Vehicle ownership in China is just one-eighth of that in developed countries, according to Bernstein, and it’s possible China’s Strategic Petroleum Reserve may view the weakness in oil prices as a buying opportunity.

However bullish they may be about long-term possibilities, investors in oil stocks will need to decide how patient they can afford to be in the wake of the summer swoon in crude prices.

1Thomas Streater, “Oil Slump Won’t Last; Which Stocks to Buy Now,” barrons.com, Oct. 20, 2014.

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