Crude Realities

It's once again time to put on my oil analyst's hat (mesh ball cap most likely) and regale you with tales from my sordid past. As you may remember, I started my Bay St. career as an equity oil analyst. The lessons learned in those halcyon days of the oil patch in the 80s' are never far from my thinking. Following from that, my recent call to sell oil above $70 this year was not just luck. The school of hard knocks in the first decade of my career has, again, served me well.

That era taught me what to look for when a cartel fails.

All through 1985, OPEC members were bickering. Iran, Iraq and Kuwait had been ramping up their production at the expense of Saudi market share. The Saudi King, over the advice of the then oil minister Ahmed Yamani, broke ranks and ordered oil production to be maintained. Those levels too were too high for the market to absorb. By June of 1986, oil had collapsed. The Saudis, by not taking production cuts in order to support prices, had prompted what turned into a fifteen year bear market in oil.

Again, in the fall of 2014, Saudi Arabia flooded the market with cheap oil in an attempt to discipline the over-producers in the faltering cartel. Political rival, Iran, had been ramping up production. The pesky Yanks had discovered how to efficiently produce oil from shale. Russian production reach new highs. The Saudis were itching for an old-fashioned market share war once again.

It caught many by surprise, but not me. History was repeating. The investment community, composed mainly of participants who were in Tim-bit hockey in 1986, was unable to process the news. It took months for estimate revisions to stop falling.

Below is the 35 year chart of oil prices. I have circled the catastrophic failure points when production market share wars erupted, with devastating consequences.

In 1985, oil had been comfortably levitating at $28 following the economic recovery that followed the 1982 recession. With the sudden collapse of the cartel, oil quickly crashed to below $10. A multi-year trading range market ensued, as excess productive capacity was slowly worked off.

The horizontal lines on this chart represent the marginal cost of bringing on the new production for the high cost producer. Prices above that line are highly unlikely to persist. The ceiling is well defined by the cost of incremental supply. The 2015-18 line is in the $60-65 range.

OIL PRICES1982-2018

There were a number failed rally attempts during the 1986-2000 period. In 1990, the Iraqi invasion of Kuwait allowed prices to break briefly above the resistance level of $28. It was only a short lived price spike. Within a week of the U.S. expulsion of Iraqi forces from Kuwait, the prices collapsed back into the range.

The second big price break, 2014, is still affecting the oil markets today. Investors and, more importantly, speculators have now re-learned the lessons of 1986 the hard way. In commodities, it is important to remember the marginal producer sets the price. Saudi oil is economic at $8-10 a barrel, based purely on lifting costs.

This year we had an attempted rally, one that has failed spectacularly. Earlier this year, the threat of U.S. sanctions on Iran emboldened speculators into loading up on oil. Speculative positions in the oil futures market were ramped up in advance of the November deadline. Many oil analysts called for $100 oil. Fat chance.

Markets have a way of making the most people wrong. The speculative positioning this year had become very crowded, with devastating results.

OIL PRICE & SPEC POSITIONS 2007-2018

As the sanction deadline approached, and with gasoline prices rising to four year highs, the U.S. administration blinked and allowed exemptions on Iranian production. Suddenly - no shortage! A rapid unwinding of long positions by speculators cratered the market in a matter of weeks.

I view the current bear market in oil as the similar one that which prevailed in the nineties. The market is trapped in a trading range between $40 and $60 and is likely to have many failing rallies. It may be many years before enough excess production is worked off and the market is in shortage. As we are now seeing, there is plenty of $70 oil. Given the huge increase of productive capacity coming from the Permian basin next year, as pipelines are built, I can't see much upside to oil for the foreseeable future. We are trapped in a long, grinding sideways market for oil.

The Saudis, perhaps aided by Russia, may attempt to restore order and curtail their production soon. But just like the eighties and nineties, the stability of the cartel will be questionable. The Kashoggi affair plays a part in all this. U.S. - Saudi relations have been badly damaged, especially given the analysis by the CIA. What better way for the Saudis to placate U.S. anger than to keep production high enough to suppress oil prices? Disgustingly, Trump has given MBS a free pass on murder charges in exchange for cheap oil.

With high cost producers in the oil market profitable at levels above $70, we know prices above that level are suspect. But where, prey tell, is the bottom?

The answer is, I don't know, but what I do know is that, like any commodity market, the last barrel 'prices' all the rest and that barrel is produced in Saudi Arabia at $10. It's now up to the House of Saud to let us know how much budget pain they can withstand. And do they want to invoke Trump's ire? Time will tell. Like the 1980s example, it is a long road back.

TWO-BIT COIN

We are now seeing the final capitulation phase for bitcoin. How do I know this? Like oil, the cost of production is a factor in the long run determination of price. By design, Bitcoin gets more expensive to produce, as time goes on. It's no different than it is for any commodity. The cost to mine a new bitcoin is purportedly in the $6-7,000 range. The forced selling we are seeing from the busted ICO market players is unlikely to stop any time soon. Bitcoin is now just like any other commodity. The marginal seller sets the price prices for all the holders and the specs are getting sold out. But the intrinsic value of Bitcoin is higher than today's price.

Where is the bottom? No idea. But Bitcoin is the equivalent of $20 oil, $1.50 copper or $500 gold. Tempting.

RISK MODEL 2/5 - Risk Off

The AAII BULL/BEAR ratio, at 54%, is the lowest reading of the year. However, the models says wait til people regain their composure and start to like stocks again.

The Copper/Gold ratio has failed to break higher, most likely a reflection of the worsening outlook for global growth and tariff sabre-rattling from Trump. Not good for taking economically sensitive positions.

The $VXV (3mo VIX) is stuck above the 20 level and must recede to below 17 for a risk-on signal.

The XIU RSI has recovered, and the ratio of price to the 200 DMA is at 97% - both in the risk-on zone. Is it just a temporary

lull before the renewed selling pressure?

The market is hyper-sensitive to the outcome of the G20 meeting this weekend. Handicapping the outcome is difficult. Some think Trump's gambit is to talk tough and come up with a quick deal. The bigger risk is that China is playing the long game, willing to take the short term pain on a protracted slowdown created by tariffs. They believe Trump, and his blow-hard cronies are soon likely to be preoccupied by the fight for the 2020 White House. They can wait him out.

They have taken 40 years to create the intellectual property black hole at the centre of the Chinese industrial complex, and are not likely to give it up without a fight. Consequently, there is a high potential of a hissy-fit from Trump and renewed downside in the markets next week.

Judging from Clarida's two handed comments this morning, the FED is likely to walk a fine line - saying nothing new. Any dovish u-turn in Chairman Powell's thinking (we hear him tomorrow) is looking more like hope as long as economic data is mixed and markets hold these levels. Again, hope is not a strategy. Consumer confidence, out this morning, was supportive of the hawkish views we have been hearing all along. Three to four rate hikes next year is a scenario still on the table.

Tricky eh?