They threw the kitchen sink at oil today.  Nearly everything that could push up oil prices happened.  There were three - count ‘em three - significant oil crises.

1. the Bournemouth strike that could take 700 kbpd of North Sea oil off the market for a week or longer is set to start Sunday,

2. Nigerian rebels destroyed pipelines causing Exxon to take 200 kbpd off the market for an indefinite time, and

3. There was some sort of armed conflict rumored to have occurred between an Iranian vessel and a U.S. military contractor.

Note the context: in just the past two months oil prices have made a remarkable run from the psychologically significant $100 level to nearly $120 - 20% in a very short time.  The run has been even more noteworthy for the bearish environment in which it has occurred: a weak first world economy that seems to be getting weaker, slower growth in the developing economies, and recently increased oil supplies from Iraq. 

And yet, today - with all the bullish news a bull could hope for - oil could not make a new high.  The inability of oil to run past $120 today in the face of oil chaos  and in the midst of a strong bull run is truly remarkable, I think.  Therefore I judge that today’s action could mark a temporary end to oil’s upward momentum, a possible temporary top in the oil price.  Bull markets always contain periods of sharp pull-backs.  I suspect that today could mark the start of one of them, particularly if the dollar strengthens due to the imminent end of the Fed’s rate cuts. 

Let’s bear the longer term perspectivein mind.  Oil - I believe - is a few years into a ten year or so run from $30 to perhaps $300 or even $500.  It has thus traveled perhaps a third or a fifth of the way with just one substantial pullback thus far when it dropped 35% from the $70’s down to the high $40’s over five months from August, 2006 through January, 2007. 

Clearly there will be other pullbacks.  If one is starting now it will almost certainly test $100.  If the dollar strengthens substantially it would not be at all surprising if we see a similar 35% decline that could bring oil back into the $80’s again. 

If a substantial oil price retreat happens, the EIS portfolio would be seriously hurt.  As of today, it is up for the year to date by double digits thanks to the strong results of the past three weeks’ rally.  I do not want to lose that gain.  Therefore, I judge it time to step aside from the oil market to a large extent as a risk management move.  This is similar to the action I took in January to step aside from the the general market as it began to roll over due to the credit crisis.

As loyal readers know, I struggle with the conflict of wanting to be a long term investor and also wanting to protect my portfolio from potential down drafts.  As a result, I sometimes decide that I must trade around my positions, putting on short term hedges and taking profits on stocks I want to own in the long term. Today marks such a time and here’s why.

My sense is that there has been a fair amount of speculative air blown into the oil market in the past few months.  It has become a way for fast money guys to make some profits - a refuge from stocks during a time when the stock market had become bi-polar with volatility off the charts.  But now there are signs that uncertainty in the financial sector is abating.  True, the economy is still weakening and could weaken further and stay weak for a long time. But the end of the financial crisis means opportunities for equity investors. Thus it makes sense that a lot of money that has been put into commodities will soon want to move on. If the U.S. dollar strengthens as the Fed completes its easing moves, that could be the catalyst to reverse the speculative move out in oil.

On top of these technical trading sorts of considerations, the fundamental global supply/demand picture for oil is moving over the next year to two years into the weakest time period that is likely to obtain for the foreseeable future.  As Lehman noted recently, two huge Saudi fields are scheduled to come on stream over the next year.  They will be the last big fields to be developed in KSA for a long time, as recently announced.  Also, Iraq is increasing its production and has the potential to grow production significantly further.  Iraq is one of the few major oil suppliers with the motivation to grow production; most others are now oriented toward hoarding their supplies.  Finally, just as new supplies are coming onto the market through 2009, global demand growth is slackening due to the economic turmoil that is spreading from the U.S. 

I think the prospect of much calmer and lower trending oil markets for up to a year or possibly longer could add to the technical trading factors discussed above to help create a period of pull-back for the price of oil and therefore for the stocks of oil and, perhaps, oil service companies. 

Starting in 2010 oil fundamentals should cause the trend toward higher oil prices to resume, perhaps in spades.  There is little new production scheduled to come on stream after 2009 and hardly any after 2014.  Oil demand will continue to grow from the present onward.  And the trend of gigantic old fields, perhaps including KSA’s Ghawar field, to decline rapidly will keep supplies reasonably tight even during the next year or two (I doubt we will see oil under $80) and will tend to accelerate in a few years.  Mexico will go into decline in 2010.  Russia may be in a more rapid decline by then.  The major new fields in the Gulf and offshore Brazil will not start to flow significantly until 2015 and will not reach their peak of potential until 2020. 

To a large extent, I have stepped aside from the market as it relates to oil exploration and production stocks and have hedged my oil services holdings with shorts. The fact that I have decided to step aside for now does not mean I am net short or that I have no position in oil equities or futures.   I do.  For example, I am not selling my position in Canadian Oil Sands Trust or Transocean, two core holdings.  But I have taken steps to protect the substantial profits that the rally in oil prices has provided to the EIS portfolio in early April.   No doubt there will be days when I will regret that decision, but I intend to give it some time to see if I am right.   

In the meantime, fundamentals remain strong for natural gas and for oil and gas services and drilling companies.  Whether the market will rewards such good fundamentals if the price of oil goes into decline is a dubious proposition, but possible.

Tags: peak oil energy investment

This entry was posted on Friday, April 25th, 2008 at 7:01 pm and is filed under Investment Ideas, Price of oil, oil supply. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.