About That Oil Rally...

Written By Briton Ryle

Posted April 18, 2016

Yesterday, on Sunday, April 17, the latest “most important OPEC meeting ever” took place in the Qatar capital city, Doha.

Why was it so important? Well, once again, it was hoped that OPEC could reach an agreement to stop increasing oil production and flooding an oil market that’s already brimming with supply…

Now, the same thing was hoped before the last “most important OPEC meeting ever” back in December of 2015. That time around, oil rallied to $42 a barrel ahead of the meeting. But that rally was all for naught: oil fell to $39 immediately after OPEC was unable to come to any agreement. By mid-January, oil prices hit $28, and in mid-February, they hit $26. 

So last night, in the wake of the latest most important OPEC meeting ever, oil prices were down as much as 6%. And it’s because the grand architect of the unilateral production freeze — Saudi Arabia — basically walked away from the bargaining table.

Yeah, that’s right. Oil prices (and stocks) look like they will get taken out to the woodshed again. And given the weird but reliable correlation between oil and the stock market, stocks are likely to head lower, too, after “the most important OPEC meeting ever” failed to deliver the promised production freeze.

What Do the Saudis Really Want?

This weekend’s production freeze meeting basically fell apart because Iran doesn’t want to freeze its production at current levels. That’s because its current production is capped by sanctions. It wants to raise its production to pre-sanction levels, but it hasn’t had time to do that since sanctions were just recently lifted. 

The Saudis didn’t want this to happen. They don’t like Iran too much. And so they killed any agreement because Iran didn’t want to participate. 

Saudi Arabia is what’s known as a “swing producer” of oil. It has a unique ability to pump more or less oil in response to market conditions. Normally, the Saudis are the ones who cut back when oil prices get weak. But that changed in 2014. The Saudis started to flood the market with oil to drive prices lower. 

The Saudis wanted two things: One, they wanted to drive weak oil producers like U.S. shale companies out of business. And two, they wanted to reassert themselves as the leader of not only OPEC but the whole oil market by forcing all oil-producing countries to follow their rules. 

And frankly, they’ve been pretty successful. Most oil producers were ready to sign off on whatever the Saudis wanted…

But here’s the thing: it’s become common knowledge that the oil markets will be perpetually oversupplied unless the Saudis cut their production levels. However, that’s not exactly true…

The Chart of the Day 

Here’s a chart from Bloomberg that shows what’s really going on in the oil market…

oil surplus fades

At the end of 2015, the oil markets were oversupplied by around 2 million barrels. But the International Energy Agency (IEA) says that OPEC production has fallen by 250,000 barrels a day sine January 2016. By the end of this year, even at current production levels, oil supply and demand will be much more balanced.

Surprised? Well, don’t be…

Non-OPEC supply is expected to fall by 700,000 barrels a day by the end of this year. And yes, part of that drop is coming from the U.S., which just saw oil production fall below 9 million barrels a day for the first time in a year and a half. The world is likely to produce less oil. But that’s only part of the equation…

Even with weak global growth, oil consumption is expected to rise by 1.1 million barrels a day this year and another 1.2 million barrels a day in 2017. 

In other words, the oversupply is going to get absorbed pretty soon. This is a textbook supply-and-demand event.

Supply and Demand 101

If you have too much of something, like oil, the price falls at the same time that people buy and use more. That’s what we are seeing with oil. Demand is rising, and production is just now starting to fall. 

But as the price and production falls, the stage is set for prices to rise again when there is not enough oil to meet the market’s needs…

We are at the point now where that dynamic — an undersupplied oil market — is in sight. And the funny thing about oil production is that it takes some time for most production to ramp up once it’s gone idle. 

It will likely take a year for oil storage supplies to really start falling. But prices are forward-looking. Oil prices will start looking forward to the day that there is not enough. 

So watch oil prices and stocks this week. The 6% drop in oil prices last night has already been shaved to a 4% loss. And while there’s no reason to think that oil will simply reverse its downside and trade in the green soon, there should be no doubt that the days of oversupply are coming to an end. 

The best profit opportunities will come from U.S. oil companies with strong balance sheets. Think Continental Resources (NYSE: CLR), Marathon Oil (NYSE: MRO), Oasis Petroleum (NYSE: OAS), and Diamondback Energy (NASDAQ: FANG). 

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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