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Why Oil Will Rally in 2016

Written By Geoffrey Pike

Posted January 18, 2016

oilpuThe price for a barrel of crude oil recently fell below $30. If someone had predicted this price 15 years ago, it would have seemed like a reasonable prediction. In January 2001, the price was right about where it is today.

If you take price inflation into consideration, then the price of oil is down from 15 years ago. The problem is the major roller coaster in between.

In June 2014, a barrel of oil was trading for over $100. In the course of just over 18 months, the price has dropped by over 70%.

For consumers – especially American consumers – the drop in price is positive. It means cheaper energy prices, which we especially see at the gas pump. If you are in the oil business, it may not be such a good thing. If you are an investor in energy companies, it has likely been brutal for your bottom line.

The biggest implication here is oil’s relation to the overall economy. While oil is a global commodity, the U.S. is obviously a major consumer, along with China. And while lower oil prices should be celebrated in one sense, we should also be concerned about its signaling an economic downturn.

To be sure, lower oil prices do not cause an economic downturn any more than overall price deflation causes an economic downturn. But it is a possible symptom. Oil prices are likely down for a combination of reasons, including expected higher supplies in the future, along with declining demand. It is the declining demand that signals weakened business activity.

The problem we have here is that we don’t know how much of the 70% decline in price is due to increasing supplies and how much is due to declining demand. But I believe it would be a mistake to attribute increasing supplies to most of the decline in the price.

The House of Saud

Saudi Arabia has been in the world news more than usual lately. For the House of Saud – the ruling royal family in Saudi Arabia – it is mostly bad news. The world is watching the brutality of the ruling monarchy, especially with the hundreds of beheadings.

When you add in war with Yemen and conflict with Iran, Saudi Arabia is really on shaky ground these days. In addition, the House of Saud relies on much of its “income” from the sale of oil. With oil prices way down, the revenue going to the ruling family is way down. Saudi Arabia is not like Dubai, where tourism and finance dominate and oil sales are secondary.

It is ironic that Saudi Arabia is being hurt so badly by the declining oil prices because it was Saudi officials who essentially made the decision to keep output high instead of cutting back production.

When Saudi officials originally announced this, some speculated that they did it as a favor to Americans in order to hurt Russia. Others speculated that the Saudis maintained high output in order to put the shale oil fields in the U.S. out of business. It may work, but the country likely most hurt by the declining oil prices is Saudi Arabia itself. The House of Saud may put itself out of business.

The House of Saud is not necessarily well liked by the general populace there. Many think that it is only the support of the U.S. government – economically and militarily – that keeps the royal family in power. And lately, there are even signs that the establishment inside the U.S. is turning a little sour on the House of Saud.

If someone had told me several years ago that the House of Saud had an increasing chance of losing power, then I would have thought the oil price would be going higher. But there are a lot of factors at play here, and the market is bearish on oil right now. In addition, if the House of Saud does lose power, oil should continue to flow out of Saudi Arabia, unless there is an all-out war. But even a short-term conflict could disrupt supplies.

If the House of Saud falls, it may have even bigger implications for the so-called petrodollar, but we will not dive into that subject here. Still, if you think the House of Saud is likely to fall, this would be one of the few (but not only) reasons to be bullish on oil right now.

Bubbles and Busts

Oil started its descent in the summer of 2014. Oil had originally hit its all-time high in the summer of 2008. It is interesting to note that the price began falling just before the worst of the financial crisis became known. Was this a prediction by the oil market?

After falling just below $40 in early 2009, it began its ascent higher with the stock market. But stocks have been able to hang on longer, at least up until the end of 2015. For oil, the bust began over 18 months ago.

Since 2008, the Federal Reserve has increased the adjusted monetary base approximately five fold. It ended QE3 in October 2014. Even though we have not seen massive price inflation, the Fed’s easy money has blown up asset bubbles.

I like to say that oil was the first bubble to have burst in this cycle. I understand one could make a case for commodities in general, but I think oil is really the big one. While gold and silver have certainly gone down in recent years, it is not as clear-cut as the huge bust in oil over the last year and a half.

And again, the declining oil price is likely a sign of economic weakness. This is becoming more and more evident in China.

When the oil bubble burst in 2008, it was a few months ahead of stocks. This time, it appears to be 18 months ahead of stocks.

The big question with oil is whether we are finishing up the bust stage, or does it have further to go? My short answer is that it could easily have further to go if we fall into recession.

Still, even if we have a global depression, the price of oil isn’t going to zero. It probably isn’t going to $10 either.

In 2008/ 2009, the major slump in oil only happened over a period of about 8 months. It was really less than 6 months from the time that the Fed started pumping in new money before the price started rising again.

Therefore, we have to consider that if the Fed starts QE4 – or whatever it will be called – due to the down stock market and possible recession, then oil could quickly recover, even before the economy is out of the downturn.

Call me a short-term bear on oil due to the likelihood of further weakening in the economy. But I believe this could turn around quickly, especially if the Fed tries to prop up the economy again with more easy money.

Energy stocks should have a place in your portfolio. Right now, it should be a very small place. When the Fed announces another round of money creation, it might be a good time to buy on this very large dip that we have experienced over the last 18 months.