Timing the Coming Monster Trade in Oil

Would you like to retire young? Or even retire old? How about just retire next year? There is a trade shaping up that is going to be a maker of fortunes on a life changing scale for those who time it right. I’m talking of course about the inevitable rebound in the oil price that is out there on the horizon somewhere. This isn’t one of those contrarian, I’m-smarter-than-everyone-else trades. Everybody is eyeballing this one right now, and that means when the rebound starts, the money piling into the trades in everything from oil stocks to futures and ETFs will be truly stupendous.

The risk, as with any trade of an opportunistic nature, is the timing. When to get in, when to get out. One might even go so far as to say that this is, in fact, the art of the trade.

There are a few metrics that need to be watched that will signal growing imminence of a reversal to the upside.

There’s no Oil Glut

The biggest problem with the current plunge in oil prices is that the ‘glut’ of oil described in mainstream hysteria media as the cause is not really a very accurate way to describe what is essentially a temporary supply imbalance. As the chart below demonstrates, we are trending toward 5 million barrels per day more production than consumption. At least, that is the takeaway from the right axis.

But as the intertwining consumption and production lines in blue and green amply demonstrate, there’s really not much deviation from normal now, nor in the future. Certainly not enough to justify a 47 percent plunge in the oil price. So ostensibly, the market, always trying to be the perpetual oracle in predicting the future, is reacting to this chart below, and its implications:

Here we see that while petroleum production in North America will be just under 1.5 million barrels per day in 2014, expectations are that is will ease to 1 million barrels per day in 2015. More importantly, Russian production is seen dropping substantially, so the present supply imbalance will easily be compensated for by decreasing production as low prices continue to sideline rigs and cause budgets to be trimmed.

All Eyes on Russia

Call it conspiracy theory, call it contrarian. There’s no doubting that the oil price is being affected by G7 attitudes toward Russia.

While the U.S. is suffering along with Canada, Australia, Norway, Mexico and the Middle East economically from lost oil revenues, this is likely deemed acceptable collateral damage, considering that there is an opposing positive outcome to low oil prices, in that the energy and transportation costs of goods are getting cheaper. So air fares will start to come down next year, even as airline profits improve. The more dependent an economy is on oil, the worse it will fare in the current ‘oil-as-weapon-of-mass-economic-destruction’ era.

But one of the signals that such latent intent will begin to evaporate will come should there be anything resembling a capitulation from Russia. This could come in the form of Putin being ousted, a negotiation for suspension of sanctions in exchange for a complete withdrawal from Ukraine and even perhaps the Crimean peninsula (unlikely), or a complete economic collapse in Russia that would have a similar effect to the Wall coming down, resulting in a democratically elected government (at least more democratic) than the current one, whose power and mandate is essentially held under threat of violence against dissenters.

Any such capitulation from Russia would constitute a victory for America and her allies, and that would certainly engender a global preference for higher oil prices in the interest of better economic stability.

Drill Rig Count: Lagging or Leading Indicator?

The number of drill rigs at work in the field is purely indicative of how much oil is going to be on the market in 60 to 90 days. That’s because, from spud (initial drill hole commencement) to tie-in (bringing the well’s output into a gathering and transportation system where it can be delivered to market) is on average that time frame. So when drill rig count goes down dramatically, you know that future short term supply of oil is going to go down too. Assuming the lost rigs in one jurisdiction are not compensated for in another.

The relationship between drill rigs being deployed and the oil price is evident in the chart above. But the time it takes for drill rig deployment to ease lags the fall in the price of oil. Operators don’t pull rigs and drop exploration budgets as soon as the oil price comes off. The trend has to solidify, and its only when it continues and demonstrates longevity that companies tighten up and pull rigs out of the field.

So in this sense, rigs are a lagging indicator. Historically, rig counts begin increasing only after sustained recovery in oil prices strengthens into a secular trend.

The Canadian Association of Oilwell Drilling Contractors (CAODC) anticipates that rig utilization in 2015 will average out to 61% in the first quarter, 19% in the second quarter, 41% in the third quarter and 46% in the fourth quarter. Mind you these estimates are published based on existing anticipated budgetary expenditures which may be modified at any time in response to deteriorating or improving prices.

My bet is the best indication of an imminent reversal in prices will be the Russian economy. With Putin coming under increasing pressure to do something, he remains defiant. His recklessness may be the cornerstone of the West’s strategy. Counting on him to become increasingly aggressive as he is backed into a corner, that will eventually become his undoing.

If Putin gets the boot, oil prices will snap back so fast, the opportunity will come and go in a heartbeat. Playing the option trade in the commodity itself -hedged on both sides – will likely be the safest way to go. Buying shares in the companies with the highest beta to oil price will likely yield better returns, but that trade will demand more patience. Either way, you don’t want to miss out.