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Oil Plunge is Political, Not Economic

Investment Strategies During Depressed Crude Oil

Written by Briton Ryle
Posted November 25, 2014

What is the world is going on with crude oil? After falling more than 31% from $107.26 in late June to as low as $73.22 a week and a bit ago, oil finally showed signs it had established a bottom by rising to as high as $77.83 on Friday, prompting many analysts to declare a bottom had been set.

But yesterday crude oil failed to rise higher than $77.03, causing many to forecast prices to fall once again, perhaps past the recent low of $73.22, all the way down to the $68-69 area.

While such low energy prices are great for consumers who are saving a bundle on gasoline for their vehicles and gas heating for their homes, such low prices are devastating to the oil industry, especially to its fastest growing segment – the frackers. Fracking is an expensive process for extracting the harder to reach oil and gas trapped inside of less porous rock, such as in the shale deposits of the Bakken fields in North Dakota and Montana.

By average estimates, crude oil needs to be between $70-$74 for these extractors to stay in business, meaning that another plunge in prices could cause many operations to shut down, triggering sell-offs in their stocks which ultimately spills over into other energy sectors.

So is this the future of crude? Are lower prices here to stay? Should investors dump their energy holdings and stay clear until the spilling stops? Even more worrying, is the falling oil price telling us that the global economic recovery is stalling, which will in turn cause a tumbling of all stocks clear across the board?

Not at all. In fact, the falling oil price has nothing to do with a failing economic recovery. Many believe the plunge in prices is not even driven by economics at all, but is politically motivated – aimed at bringing two rogue nations to their knees: Russia and Iran.

And they’re almost there; they almost have these two trouble makers right where they want them. It won’t be long now before oil prices climb right back up again.

Russia and Iran Feel the Squeeze

According to the CIA Worldfact book, Russia produces more than 10 million barrels of oil per day, exporting nearly half of it at some 4.8 million barrels per day, contributing nearly 10% to its GDP.

Iran, for its part, produces more than 3.6 million barrels per day, exporting more than two-thirds of it at some 2.5 million barrels per day, contributing more than 20% to its GDP.

The recent plunge in oil prices of more than 30% has thus cut some 3% of Russia’s GDP and more than 6% of Iran’s in just the last five months.

Neither country was exactly prospering in the first place.

Such losses to their export income and GDP have provoked both Russia and Iran to push their OPEC partners to cut oil production in an effort to reduce the global supply of crude and drive the price back up. Russian officials met with counterparts in Saudi Arabia and Venezuela last week, while Iranian officials are scheduled to meet with Saudi officials later this week.

What are Russia and Iran hoping to achieve?

“Russia might agree to cut output if OPEC reduces production by 1.5 million barrels a day,” answers Olivier Jakob, managing director of Zug, Switzerland-based consultant Petromatrix GmbH. Iran, for its part, is hoping to secure a 1 million barrel a day reduction from the cartel.

Russia is already willing to cut its own production by 300,000 barrel per day. But neither Russia nor Iran can reduce production alone, since reductions by just two countries would not be enough to turn oil prices higher. As a result of going it alone, Russia and Iran would merely be generating less income as they export less while the oil price remains low, ultimately shooting themselves in their feet.

Will OPEC oblige their desperate partners? “Societe Generale SA sees a 60 percent chance that OPEC will cut output by 1 million to 1.5 million barrels a day,” Bloomberg reports. The cartel is to meet on November 27th, with markets getting ready to move dramatically one way or the other. If a reduction is announced, crude oil prices could rise by a full 10% over coming weeks to overtake the $80 mark. But if no reductions are forthcoming, prices could continue to plunge, possibly down to the low $60s.

It’s Not Economic; It’s Political

But investors needn’t be overly concerned, and should not be dumping their energy shares over this. There is ample reason to believe that the fall in oil prices is not a reflection of current economic conditions or future outlook, but is just a temporary ploy engineered to bring Russia and Iran back to the negotiating table.

Russian Foreign Minister Sergei Lavrov, for one, believes it is all just a political tactic employed by western powers who have won key OPEC members to their side. Lavrov accuses outright falsification of crude oil inventories which are being “artificially distorted” by “non-objective factors.” He openly protested that the oil market “must be free of attempts to influence it for political and geopolitical reasons”.

What “political reasons” might western powers have for artificially skewing their crude inventory levels higher to move the crude price lower? To pressure Russia into withdrawing from eastern Ukraine, and to bring Iran back to nuclear arms negotiations.

In Iran’s case, a second deadline for reaching an agreement for Iran to abandon its nuclear technology program was missed yesterday. The West is eager to bring Iran back to the table.

“Between now and January 2017 [when Mr. Obama leaves office], Obama wants to avert an Iranian bomb and avert bombing Iran,” explains Karim Sadjadpour, senior associate at the Carnegie Endowment for International Peace. “Extending negotiations is not ideal but it checks both these boxes.”

Israeli Prime Minister Benjamin Netanyahu agreed, as Israel’s security would be that much more in jeopardy should Iran develop nuclear weapons. “The right deal that is needed is to dismantle Iran’s capacity to make atomic bombs and only then to dismantle the sanctions,” he expressed his support for extended negotiations with Iran.

Investors Should Buy Not Sell Energy

While several economic sanctions against Iran have long been in force, we can adding falling oil prices as one more “sanction” intended to twist Iran’s arm to signing a deal. Once such a deal is made, we could then expect the West to “dismantle the sanctions”, including returning the oil price back to their true levels.

How can we be so sure that crude prices are being artificially skewed? There simply has not been enough increased production of oil to drive oil prices down more than 30% in less than five months.

As Barron’s put it last month, “The fact is that the oil supply-and-demand balance does not shift so quickly as to justify a fall of 13% in one month, and especially not - as at one point last week - a three day drop of more than $6/bbl in the global benchmark Brent.”

Any artificial skewing of inventory levels to drive crude prices down can be considered just one of those sanctions imposed on both Iran and Russia for misbehaving. And as such, are only temporary in nature.

Research brokerage firm Sandford C. Bernstein “takes a much more bullish view over the longer term,” Barron’s continues, “noting that oil price should trade around the marginal cost of production, which they estimate to be around $100 a barrel… Despite suggestions leading members of [OPEC] will not cut output, Bernstein says it is likely they will reduce production to support prices.”

Investors, therefore, should not be overly concerned, nor fear that the fracking boom in the mid-west is on its last breath. Shale oil is vital to ensuring America’s energy independence, and prices will be returned to higher levels in time to save those operations from extinction.

Any further dip in energy prices should be viewed as a golden opportunity to snap up some great stocks at bargain prices.

Joseph Cafariello

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