We care about oil because oil’s year-over-year change impacts inflation. Inflation is one of many important economic indicators. Hence, it impacts the S&P 500, which is what we trade. When oil’s year-over-year change goes up, inflation goes up. When oil’s year-over-year change goes down, inflation goes down.
We agree with our colleagues in our sister fund, who think that commodities will be in a bull market for 2-3 years (2017-2019). Over the long term, commodities and oil move together. Here’s the medium-long term bullish case for oil.
*Oil is notoriously hard to trade, unlike the S&P 500. The S&P is easy to understand. Over the medium-long term, the S&P follows the U.S. economy. If you understand the U.S. economy, you can trade the S&P. Oil is completely different. Oil is impacted by too many factors – supply, demand, the economy, geopolitical tensions, seasonality, news, etc. So please take our thoughts on oil with a grain of salt.
Long term bullish case
Oil has trended lower year-to-date in 2017 because U.S. oil production has soared while production costs remained low. Shale costs around $41 a barrel to produce in the Permian basin. Historically, the cost of shale production has been the floor for U.S. oil prices. When shale production costs fall, oil prices fall in the medium-long term. When shale production costs rise, oil rises in the medium-long term.
The cost of oil production is about to rise.
- The low-hanging fruit in the Permian basin have been picked (lease costs are rising).
- Servicing costs for oil-fields are rising.
The best drilling spots in the U.S. have already been taken. Hence, productivity per oil rig is already falling. This factor alone will slow down the increase in oil supply.
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With the best spots taken, lease costs in oil fields are rising. But more important than lease costs are servicing costs. Oil drillers typically hire OFS subcontractors (oil-field services) to work the rigs. When oil crashed from 2014 to early-2016, there was a massive excess supply of OFS companies (too many companies and not enough rigs to work). Drillers were able to keep OFS costs low throughout 2016 and early-2017 because of this hangover. But after a year of increasing production, this hangover is mostly cured.
The oil industry estimates that OFS costs will rise 20% in 2017, meaning that the cost-of-production per barrel will rise 15%. If these estimates are correct, then the cost of production in the U.S. will rise from $41 to $47.
Here’s another interesting point. When oil inventories increase sufficiently enough, oil prices fall. When inventories fall sufficiently enough, oil prices rise.
As you can see in the above chart, the cumulative year-to-date change in oil inventories turned positive in February 2017. Oil topped in February. Oil inventories have fallen since April. Will oil prices really start to rise when cumulative inventories turn negative? Perhaps.
The bottom line is simple. Oil production costs are rising. This means that oil will start to make higher lows. We think oil will slowly swing higher from now until late-2017. Then oil will really start to soar from late-2017 to 2019.
The China trigger
We don’t like economic theory. Most theory is BS and works <50% of the time. However, economists have got one thing right – oil is an inelastic market. That’s why a relatively small change in supply/demand results in a massive change in oil prices.
Oil’s historical bull markets are caused by massive surges in demand or massive declines in supply. We will not see a massive decline in oil supply over the next 2 years. However, we do see the potential for a big increase in demand.
As mentioned in our previous post:
Our sister fund thinks that this catalyst will be a Chinese fiscal/monetary push in late-2017. After 5 years of internal political maneuvers, Chinese President Xi Jinping has finally gained complete political control in China. Based on our contacts in Beijing, President Xi will make a big effort to push the Chinese stock market/economy higher after the Communist party’s October 2017 congress.
The China story is the commodities story. When China’s economy boomed from 2002-2007, oil and commodities surged. When China’s economy boomed from 2009-2010, oil and commodities surged. When China’s economy slowed down from 2010-2016, oil consolidated and crashed.
If our contacts are correct, then China will experience an economic bump that can last 2 years. Under that scenario, commodities (and oil) will enter into a new bull market.
Short term – ready to break out?
Oil and XLE (energy sector) at big resistances right now. Are they ready to break out? Who knows.
Here’s WTI oil against its 50 daily moving average.
Here’s XLE against its 50 day moving average and downwards sloping trendline resistance.
*Gartman is bearish on oil right now. Gartman is wrong >50% of the time (worse than flipping a coin).
In the final 2 years of the S&P’s bull market (2017-2019), the energy sector will outperform.