The Ghost of Crude Oil Futures (Part 1)

By: Oxbury_Research

John Whitehall writes: Most people have heard the phrase, “it takes a big man to admit when he's wrong”.

Well, I'm about 5'9”, and I don't believe that people should be exalted when they do something that they're supposed to do. It doesn't make you a big man, it makes you honest. You're supposed to be honest.

I'm going to do something profound. Something most people should do, particularly those in a position or profession of dealing out commentary, suggestions, and advice – especially when there's money involved.

I'm going to tell you I was wrong about something. And I'm going to do it without giving you a bunch of padding and reminders of the other 1,349 times I was right. Those of you who read my columns may have already guessed what I'm about to say, so without further ado, here goes:

I was wrong about oil. There, I said it.

Right direction, wrong price.

A few months back, during oil's initial slide, I made it clear that I thought we (as investors) should be getting involved in oil as it broke below $90 per barrel. I honestly thought that anything under $90, and if it continued, under $80, was an absolute steal, long-term.

Regardless of whether I may still be right long-term , the continued price destruction through ever major support level was not something I anticipated. Granted, few of us saw the destruction of our entire financial system and collapse of several companies we expected to survive for centuries, but I don't see this as an excuse or justification for sweeping past predictions under the rug.

Before we head down this old, beaten, well-funded-but-poorly-maintained road, I would like to make two specific points: I enjoyed paying $1.67 for gas on Tuesday – I filled my tank for about $30. Truthfully, I'm a little embarrassed by the elation I felt, disheartened that the highlight of my day involved getting a relative deal on the fossil fuels I pour into a machine that will drag me to the mall so I can do my part in lending a crutch to a crippled retail sector and tear a small hole in the ozone layer along the way.

Ho, ho, ho. Scrooge has competition.

The second point is that the minute savings on gas does not compare in any way to the profit that stands to be made if an investor were in a long oil position when what will inevitably happen… well, happens. Should I get the chance, I'd be spraying myself with $4.00 gasoline with a smile on my face – if I own a boatload of oil stocks.

Disclaimer : I'm buying oil. Let me rephrase that – I bought oil. Not literally, of course. I'm buying derivative securities in the form of energy companies and oil funds, but essentially I'm putting myself in a position to make money if the price of oil goes north.

So what convincing argument can I provide that will instill confidence this time around? Well, let's skip the opinions based on contrived scenarios and look at the facts.

Santa's sleigh is powered by reindeer. Automobiles are not.

Let's begin with the glaring reality that people are not going to start riding bikes to work. If you can ride a bicycle to work, then you obviously live close enough that you weren't using much gasoline anyway. In other words, people are not going to stop driving altogether.

Trucking companies are not going to convert to horse-drawn carriages. Airplanes are not going to throw it in neutral and glide to their next destination. And, let's face it, it's not feasible for Americans to begin chopping down all the trees in the neighborhood to burn logs in their homes.

The countries, cities, towns, and food markets are not suddenly going to drift closer together to make travel more economical for anyone. We have to get around, and with 250+ million cars on the roads in the US alone, it is far more difficult to find/develop/purchase alternative means of transportation.

Great, so what does this mean?

Experts agree, digging costs money.

It is the contention of not just myself, but one of the world's foremost oil experts Matthew Simmons (chairman of Simmons & Company, an energy investment bank), that demand has not fallen as much as prices reflect. In fact, in a recent interview with Fortune , Simmons stated that “we don't have precise data… but there is no way demand is falling to the extent that the pundits seem to think it's falling.”

A week ago, OPEC announced a production cut, citing a slowing global economy and reduced demand as justification. The market blew off this news and oil dropped below $37 per barrel. Simmons explained that OPEC is cutting supply because they're panicked. At $40-$50 per barrel, many of these oil-based economies just “don't work”. This is because there are certain fixed costs of production that cannot be changed. In other words, it hasn't suddenly become less expensive to dig a hole.

Therefore, prices will not stay where they are now. If it means cutting production until these economies reach the price they want… or more accurately, need , then that's what will happen. As Simmons accurately points out, because of differing cost structures, $30 per barrel oil today would actually be less sustainable than the $10 per barrel oil of long ago.

It all boils down to this: Oil is a business, although many people seem to be under the delusion that it's some form of inalienable right. If a business isn't profitable, it will not run, and the energy industry is not a charity – it is, in fact, quite the opposite. Instead of running in deficit in order to make gasoline more affordable for all of us, they will more likely tighten the noose that is already around our collective necks until they get a price they can live with.

Next week, part 2 – price barriers, the possibility and horror of cutting into a balanced market, and where this is all going.

Disclosure: no positions

John K. Whitehall
Analyst, Oxbury Research

John has a solid decade of experience in the financial markets: from developing and implementing long-term investment strategies for high net worth clientele to intraday trading of equities, Exchange-Traded Funds, options and currencies. John's proven track record of accurate equity analysis coupled with a mastery of technical indicators has afforded him great success in trading equities on major exchanges.  John is most renowned among his peers in the industry for consistent, high returns during the vicious tech collapse and subsequent years of unstable trading periods through 2004.

Oxbury Research originally formed as an underground investment club, Oxbury Publishing is comprised of a wide variety of Wall Street professionals - from equity analysts to futures floor traders – all independent thinkers and all capital market veterans.

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