As the New Year's Bowls wrap up, something is at play with little notice.
Half a world away, Saudi Arabia executed a Shiite cleric (among many others in a mass execution), leading to riots and threats from Iran. This is extraordinarily serious as the Saudi regime is already struggling with the impact of low oil prices. In fact, the strong reaction could force the Saudis to change policy quickly or face serious threats that will change policy without their consent.
There are three things to know by way of background:
The oil price collapse is a function of excess supply and a very bearish outlook from investors.
It is important to note that it is not really demand weakness that has kept oil prices down. In fact, despite a sluggish global economy, demand is at record high levels globally as shown in a recent Yardini report. Demand is projected to grow again in 2016 albeit at a slower rate.
Investors have been extremely bearish. And, any small change in price could trigger a big move the other direction as noted in the current issue of BARRONS:
Mutual funds are underweight energy stocks, and JPMorgan analyst Dubravko Lakos-Bujas notes that what he calls speculators—commodity trading advisors, hedge funds, and the like—have put on record bets against oil and natural gas that would have to be covered if a surprising piece of good news hit the market. Commodity trading advisors alone would be forced to put some $10 billion into energy futures if prices rose by just 5%, Lakos-Bujas estimates. "Speculative positioning in energy is already extremely short," he says, "and a reversal in technicals could provide a significant lift for all assets tied to the energy complex."
Iran's return to the oil market was cited as a bearish factor for next year.
In the end, however, it ironically may turn out bullish as we describe below.
Saudi Arabia is financially hurting but has been pumping like crazy.
In fact, the Saudis have been directly responsible for 1.5 million barrels per day of extra production this year. This is significant because the entire oversupply (in excess of global daily demand) is projected to have been 1.4 million barrels per day in the fourth quarter of 2015. In other words, the Saudis are responsible for almost all of the oversupply that has cratered oil prices. They have done this despite the fact that the Saudis require substantially higher oil prices to meet budget needs. As we have noted before, and by their own admission, this Saudi strategy was designed and purposed to bankrupt the American shale industry and keep us dependent on foreign oil over the long run.
Now, the riots and rapidly rising tensions between Iran and Saudi Arabia may be a game changer with multiple possible outcomes. Here are four different possible outcomes:
- The increase in tensions could cause the Saudis to really ramp up production to punish Iran and her ally Russia.
- Riots could escalate in Saudi Arabia leading to a disruption in the oil fields or, worse still, a possible regime change.
- The Saudis could attempt to pacify Iran by restoring order to the oil markets, supporting higher prices.
- The Saudis could be forced to abandon their oil war. They would cutback production to maximize revenues in order to provide financial ability to pacify their population. Even a reduction of two million barrels per day could eliminate the oversupply and allow for much higher prices resulting in higher total revenues.
From a first review analysis, three of the four possible outcomes we identified would be very bullish for oil prices. This is a potential game changer. We will continue to monitor the situation closely.