Just a few weeks ago, the world was concerned about social unrest in Iraq. Combined with tensions between the U.S. and Russia (the second or third largest oil producer in the world after the U.S.), many analysts were reporting that $150/barrel oil was just around the corner. But as is often the case, the crowd was dead wrong, and the price of oil has fallen by about 5 percent in the past month. Furthermore, the large-cap and mid-cap oil ETF that is most heavily correlated to the price of oil — the SPDR S&P Oil Exploration and Production Fund (NYSEARCA:XOP) — has fallen back from its June 23rd high of $84/share to just over $78/share.
Several things have been driving the price of oil down lately. First, there were too many speculative longs in the market. As I mentioned, the crowd had turned bullish, and while there were good reasons for them to be bullish, too many investors were making that bet, and when we didn’t see a political crisis immediately escalate in Iraq traders exited the position to look for another short term opportunity.
Second, the U.S. “officially” became the world’s largest oil producer, as Bank of America (NYSE:BAC) reported that it had over taken Saudi Arabia as the holder of this title (some reports state that Russia produces more than Saudi Arabia, although the difference is minor and it really doesn’t matter so much.) It achieved this not because other countries saw production declines, but rather because it grew production, thanks to the rapid rise of hydraulic fracking. With this being the case, the additional supply drove prices down.
Third, we have seen some weak global economic data, especially out of Asia, and if the economy is weakening then demand for oil declines. Investors should note, however, the strength in other economically sensitive commodities — particularly base metals such as copper, zinc, lead, and silver — and so this may not be a legitimate reason.
Fourth, the Federal Reserve announced that it would stop its quantitative easing program in October, and this has had a negative effect on oil and stocks, although again we are seeing recent strength in Treasuries (the asset that the Fed will stop buying) and metals (e.g. the base metals and gold.)
So we have several candidates that could be driving prices lower. But is it now time to bet against this downtrend on higher oil prices? While we may not have reached a bottom, it seems that the oil price is looking to start an uptrend, and we have seen very strong support earlier this year in the mid-$90/barrel range. I suggest that if you are interested in taking a position in oil that this level would be a good place to enter. There are definitely bullish arguments for oil, despite the bearish arguments that I have pointed out above.
First, with respect to my first point, the bullish speculators are exiting the oil market and many of them are likely taking bearish positions. We can easily see the speculators get overextended on the downside and they could be forced to cover their shorts and cause a short squeeze.
Second, while geopolitical tensions have retreated from the headlines we have to be concerned about potential shortages if tension between the U. S. and Russia escalates, or if internal tensions escalate in Iraq. It is better to bet on these sorts of things while they are temporary off the front pages than when they are sending prices soaring.
Third, while the Fed may be stopping its quantitative easing program it still has interest rates at near 0 percent, and this is highly inflationary. We have already seen signs in the first half of the year that inflation is picking up, and I suspect that this will continue. High oil prices last month could impact the CPI reading, and this could spark bullish oil speculation.
Given these points oil and oil-related equities are starting to get interesting, and I would be looking to take a position, as I said, if oil reaches the mid $90/barrel range. Investors should consider the aforementioned XOP given its strong performance and its high correlation to oil. Investors looking for a trading position should consider the United States Oil Fund LP (NYSEARCA:USO), which tracks the oil price. However, given that this fund has several expenses, it doesn’t track the oil price well over the long-term, and so it is a trading vehicle.
Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.