I am sure everyone is aware that oil prices have fallen sharply since the beginning of 2007. Today's close under $52 was a 19-month low and represented a -33% drop from the recent highs and a -15% drop in 2007 alone. Those holding positions have passed the point of pain and are now in full flight mode.
Next support is $50 and that is a critical level both technically and psychologically. OPEC pledged to support prices at $60 but failed to backup their pledge with any real production cuts. Now the OPEC basket of crude, which trades at a discount to the benchmark light sweet crude contract, is now trading in the mid $40s.
This is a catastrophic change in fortunes for OPEC. They need higher prices to continue their upgrade and exploration programs intact and also to keep their economic and social programs functioning. Like any American consumer you end up spending whatever you make. If you get a major raise it only takes a few months before expenses rise to consume the extra income. The exact same thing is true of OPEC countries. They have a history of fast spending and even faster handouts to their favored citizens. When the income suddenly takes a +50% jump for a couple years those spending and handout programs increase to keep the peace and keep the population in line. Now that prices for OPEC crude have fallen nearly -25% in just a few weeks the budget squeeze is on.
Cutting handouts is always significantly harder than increasing them and paying contractors billions of dollars per year for oil field upgrades and drilling programs will quickly produce a significant drain on cash reserves. You would think OPEC countries would be floating in money given the price of oil over the last two years. Unfortunately most were already deep in debt from bad management and corruption and the sudden flurry of cash was a welcome sight but was quickly spent. Now they are in debt at a higher level with no hope of correcting the problem without cutting production.
Instead of cutting production as promised it appears several countries have even been pumping more oil to make up for the lower price received. Tanker tracker Oil Movements said on Thursday that shipments in January were up +350,000 bpd from December. Prices fell and producers rushed to sell more rather than cut production as promised. We should not be surprised since quota compliance is a joke in OPEC.
The current sell off in oil is way overdone even when taking into account the nearly complete lack of winter in the oil consuming American northeast. OPEC cannot afford to let the over production continue. The price is very close to a major benchmark at $50 and futures expire next week. We have seen the development of the perfect storm for oil prices and it appears we are nearing the perfect buying opportunity.
With a 3-day weekend ahead there could be some serious short covering once it appears the bottom has formed. I would recommend to anyone looking to establish new positions in the energy sector to buy any further weakness in crude oil. We may see numbers under the $51.88 close over the next week but it should be only temporary and would be a buying opportunity.
Some candidates that I feel are bargains would be PetroChina (PTR) after a -$20 beating to $125. I also like Sinopec, which failed to crack until Thursday despite the implosion in the broader Chinese market. Sinopec (SNP) at $84 does not have any LEAPS but you can get PTR, SNP and CEO in the FXI ETF we currently have in the portfolio. Just buy the lowest strike you can afford with the FXI at $103 and forget it. China is still exploding and this recent bought of selling is just profit taking from a major rally into year-end.
Other candidates would be the oil service companies, drillers or small integrated oils like MRO at $83 and HES at $47. The big guns, COP, CVX and BP have already warned so the damage has been done there. I would avoid new positions in the gas plays like UPL, CHK and ECA until the price of gas recovers from the warm winter.
I believe this sell off is about over but that belief and $5 will only get you a cup of coffee at Starbucks. I am buying the dip and believe you should as well.