Oil Due For A Major Pullback

By Matt Insley | Daily Reckoning May 6, 2013, 9:24 AM 

No, your eyes aren’t deceiving you – today’s headline is correct.

The price of oil is set for a dip lower – one way or another. Today I’ll show you why.

I’ll also explain why it’s not the end of the world for oil investors – quite the opposite actually! And I’ll share my thoughts on playing oil in the next six months…

You’d have to admit from a fundamental standpoint $95 oil is a little high, especially if U.S. crude storage (as of last week’s data) is at its highest level since 1931.

Just to make sure you’re caught up on the story take a look at the most recent U.S. storage data:

As the chart shows U.S. crude stocks are heading higher, well out of their 5-year range.

To break it down, the U.S. is divided into five Petroleum Administration for Defense Districts, or PADDs. Four out of five PADDs – the East Coast, Midwest, Gulf Coast and Rockies – are holding more crude than they did last year (the only region modestly down is the West Coast.)

There are plenty of reasons that crude stocks could be rising. On the supply side U.S. shale oil production is moving the needle higher. More U.S. oil is flowing through the domestic circulatory system, and naturally storage is rising. That explains why the only laggard PADD is the West Coast – likely because they’ve put a cork in their shale production.

On the demand side we’re seeing an equally important trend emerge.

In short, U.S. demand for oil is pulling back. Fuel efficiency is playing a strong role in lowering overall crude demand. Call it the “Prius effect” if you will, regardless we’re using less of the stuff to push our vehicles around the road.

Another trend that will keep pressure on crude demand is the abundance of natural gas. If in fact we do start seeing fleet vehicles and other modes of transportation run on natural gas, the effect on crude demand could be profound.

And lastly, the other thing that works in the favor of lower oil prices is something called elasticity of demand. Just five years ago most analysts or market watchers would say that crude demand will always remain strong. “People have to drive to work!” they’d say – and for that reason these folks believed that crude oil demand wouldn’t drop.

They were wrong. The high prices of 2008 taught us all an important lesson. In particular, demand is much more “elastic” than they thought. Said another way, high prices will curb fuel use. And as you can tell from your local news report, even at $95 oil prices are still stubbornly high, so expect a continuation of curtailing demand.

Add it all up and here’s what you have: more supply flowing from U.S. shale wells and less demand. Indeed, that’s exactly why we’re seeing crude stocks rise. It’s also the precursor for a drop in prices…

“But Matt” you may ask, “You’ve been beating the drum for ‘range-bound’ crude prices for the past year. And now you’re telling us crude prices are set to drop!?”

Sort of. Here’s the explanation…

I’ve gone on record more than once about what’s controlling the crude markets these days. Indeed, we’ve been range-bound in an area from $80-115. When things in the Middle East boil up (something we’ve referred to as the “Middle East Effect”) or when the economy gets a kick in the pants we head to the high end of oil’s price range. When things cool down, we head to the lower limits.

Today I’m leaning towards the downside of that range. Indeed, the way the fundamentals look in the U.S. and abroad I have a feeling over the next few months (6-18 months) the U.S. could be flush with oil, even more so than today.

During my recent trip to Oklahoma’s oil country it was again brought to my attention that oil production is booming country-wide – every nook and cranny of the shale patch. And the boom isn’t set to slow for years. Indeed, we’re not at the domestic peak yet, my friend.

Incidentally this boom isn’t happening world-over. That’s one of the main reasons we haven’t seen a dramatic drop in global crude prices. But that doesn’t mean we’re not in for a modest pullback here at home.

A pullback is what will get our domestic market into an efficient equilibrium. Instead of what we’re seeing now, with a full throttle attitude from drillers.

Truly, crude oil prices are either going to head lower on their own, or they’re going to be dragged there by higher domestic production.

But you’ve got to understand one thing about the crude market. Although $80 may be the efficient, no-turmoil price for crude here in the U.S., that doesn’t mean a sharp pull back in prices can’t temporarily bring us to $60 a barrel. From current prices that would represent more than a 30% pullback.

Indeed, just look at the recent pullback in metals prices. Although what I believe to be an efficient price for gold is north of $1,500, that doesn’t mean a sharp pullback can’t throw prices down below $1,350. Just like we saw in April.

Same goes for the crude market. Fundamentally, the writing is on the wall for a potential pullback.

Now let’s take a look at the chart:

Oils supply and demand have controlled the price action on the chart above. Using that same price action can tell us a good bit about where we’re headed, too.

Right now the chart appears to be consolidating, something we’ve seen several times in the gold market. And as I’ve said before a consolidation pattern usually leads to a breakout move (one way or the other.)

With risk/reward on my side I’d be betting on a move lower. Point being, I’m not a strong buyer at $95. The potential upside there is, what, $115? Barring any major development in the Middle East, I don’t see much juice to that upside move.

The downside, however, could lead us to a price in the $60s – that’s something we haven’t seen since 2010 and represents a 30% drop for oil prices.

It’s Not Over For Oil Investors

The simple thing to remember here is that a pullback in oil prices doesn’t spell the end for our energy investments. On the contrary, this kind of move is healthy for the oil industry and the crude market.

Other than being able to play the downside, there will be a lot of long-term opportunities that pop up. [Editor’s note: Okay you want a downside play? I’d take a look at playing put options on the ProShares Ultra Crude Oil ETF (UCO.) Going out to October and looking at a $25 put could be well worth your time.]

On the long side of the market, most of the midstream players we’ve talked heavily about for the past year or so will still have loads of opportunity to pay dividends and make money on America’s newfound supply.

Along with the midstream players, the low-cost, efficient oil producers will also rise to the top. Any market pullback will offer a discount on our favorites. So instead

The moral of the story is simple: keep your eyes peeled for a pullback in the price of oil. As you can see from the chart above those moves can come fast and furious.

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