A Tradable Bottom in Oil?

Oil prices continued down again this week. A barrel of crude dropped to under $34 a barrel Friday afternoon. But on Friday evening oil surged more than 10% to close the week above $37.50 a barrel on the NYMEX. It seemed traders realized OPEC could make more cuts in March and oil prices were just “too low.”

Whatever the cause for the spike was, the sharp upturn on Friday could signal a tradable bottom for a couple of reasons.

Jeremy Grantham: “Below 30, I’m definitely a buyer”

The first is the amount of buying interest in oil when it drops below $35 a barrel. In a recent interview Jeremy Grantham talks about a few of the least considered factors when it comes to oil: volatility. In the interview (view video here) Grantham states:

I thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37 in real terms. And I think it has probably jumped again. It will be revealed in 20 years to what level. But my guess is $60, $65, maybe even $70.

But what people underestimate, even in the oil industry, is how volatile the asset class is. In other words, if the trend is $65, it is fairly routine for oil to sell below half, say $30, and more than double, say $145.

And people never get that. So you don't want to be too quick to buy into weakness or sell into strength, necessarily. But it can go a long way. But below 40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.

Grantham isn’t the only one interested in buying oil at the sub $35 a barrel level. There’s a lot of interest. But to go as far as saying “I’m definitely a buyer” under $30 is a very strong statement which will attract a lot of followers.

It’s looking like between $30 and $35 is at least, if nothing else, a temporary bottom.

Oil Stock Indicator

In OPEC: Too Little, Too Late we looked at how oil service stocks can be a good indicator of changes in oil price trends. The stock market is actually a very good predictor of oil prices. Oil service stocks (Oil Service HOLDRS ETF - OIH) tend to lead oil prices (U.S. Oil Trust - USO) for the past few years. When oil service stocks went up, oil prices have followed. When oil service stocks went down, oil prices followed.

As you can see in the chart below, oil service stocks have consistently led the way. Whichever way the OIH (red line) went, USO (blue line) followed.

Now it looks like oil stocks are trending flat to slightly higher while oil prices have fallen. In the past few years, that has been a good indicator of a rebound in oil prices.

Overflowing With Oil

From a fundamental supply/demand perspective, it’s tough to imagine things getting much worse in the short-term.

On the demand side China’s economic problems are well known and U.S. oil consumption is expected to decline for the first time since 1982.

On the supply side OPEC has successfully been able to stick to its quotas and oil inventories around the world are reaching record levels.

Oil stored in Cushing, Oklahoma climbed another 1.7% this week. Now 34.6 million barrels of oil are stored at Cushing. That’s almost three times the same levels in 2004 when oil prices started marching much higher.

On top of that, a few weeks ago Frontline (NYSE:FRO) reported, “Trading companies are storing an additional 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years.”

In the end, you can make a case for oil over the medium and long-terms. We’ve been through the long and short case for oil before and looked into what the oil bubble left behind. But when we’re focused mainly on the short-term, it’s plain to see there is a lot of interest at the sub $35 a barrel and oil stocks are signaling a rebound in oil prices is on the way. I’m part of that interest and bought on Friday, but I’ll be a willing seller into any rebound.

Good trading,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Long Horizons NYMEX Crude Oil Bull (TSX:HOU)