Thursday, January 28, 2016

Upcoming Oil Mega Price Spike

The components of  the current low oil prices represent an insidious and toxic economic brew. The sustained long-term low oil prices, are a result of continued record high production domestically and internationally, excess inventory, tepid demand led by a slowing Chinese economy, and a strong US dollar in which oil is priced. Consequently energy firms have mothballed or outright cancelled mega energy projects worldwide totaling $380 billion which were undertaken years earlier during boom times to meet future global energy needs.

With respect to production, both OPEC and non-OPEC countries have been producing flat-out because of the need for revenue. The biggest producers are Saudi Arabia and Russia, the former because of unanticipated expenses supporting a war in Yemen and increasing domestic needs, and the latter because of Western-imposed sanctions. Iraq is continuing their record production, Iran will soon enter the world market with a bountiful of oil stored in supertankers and the US, despite some shale oil company financial difficulties, are still strong producers particularly with the new crude oil exports.

The restarting of mothballed projects is an operationally and financially complicated affair during a demand upswing for the following reasons:

1.       Operationally, getting these projects back on-line will not be accomplished before the excess inventory is reduced.
2.      Financially, oil companies may be reluctant to commit to continuing particular projects or will decide to have a limited restart because of the uncertainty whether new demand will continue to remain strong.
3.      Finally, the continued strength of the US dollar has limited the ability of many countries, particularly those emerging economies, from purchasing more oil to meet demand.

For this reason, these components represent a set-up for a brutal super-spike in oil prices for an inevitable market correction when demand rises which reduces excess inventory and the US dollar declines.  Even with a modest increase in demand, excess inventory will vanish and without any new oil operations coming on-line in the near future, oil prices will steadily increase. Accelerating this process will be the decline in the US dollar as more countries are able to afford to purchase more oil to meet demand.  At the same time energy companies will be scrambling to rehire oil workers and energy services, a highly specialized field, which could result in a bidding war for services raising operational dramatically.

It is important to note that these components will not necessarily move in synchronized lock-step, rather in a somewhat staggered fashion. Nonetheless, whichever component shifts first, the period from the initial change will be only a matter of months, not years before oil prices surge dramatically and remain elevated until new oil production operations are on-line.

The most likely scenario for the beginnings of an oil price increase would be the depreciation of the US dollar whose current lofty value is unsustainable and its decline precipitous. Because other commodities in addition to oil are valued at or near historic lows, the opportunity for countries to make large purchases immediately with a depreciated US dollar will be difficult to pass up. The result could be a sudden burst of intense purchasing activity for oil to transport these goods as well as to operate the industrial operations to process these raw materials.

The demand upticks may also come from China who is in the midst of diversifying their military, converting it from a largely land based military to a leaner, more muscular land, naval, air and cyber military force. For this reason they will take advantage of the lower US dollar to purchase oil to increase their strategic reserves.

Again, the timing of when this demand surge will occur is speculative however the components are in place for such a dramatic change in prices to occur. Certainly investments in oil, gas and energy related services should be strongly considered to take advantage of this upcoming energy price spike.

This article was published in SeekingAlpha.

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