Playing Crude Oil’s Inevitable Rebound

February 05, 2016

Investors have been trying to call a bottom in oil for months now. From $80 to $60 to $50 to $40, there have been countless bottom calls along the way. Yet every time, they were wrong, and prices fell even lower.

Unsurprisingly, with a track record like that, the number of people willing to call a bottom in oil has dwindled. Sentiment is extremely bearish, with most analysts calling for further price declines in the short term.

Pickens Sees Oil Doubling

Yet amidst the overwhelming bearishness, there are a few brave investors who are doing it again—calling a bottom in oil.

Billionaire oil investor T. Boone Pickens recently told CNBC that he thought the bottom in prices was reached in January and that prices would double within 12 months.

Meanwhile, traders are pouring money into the perennial day-trader favorite VelocityShares 3X Long Crude Oil ETN (UWTI)—$356 million of inflows this year. The largest energy ETF on the market, the Energy Select SPDR (XLE | A-91), has also seen inflows this year—$150 million—and is up notably from its recent lows.

Are these bargain-hunting investors prescient, or simply foolish?

One Of The Largest Declines In History

As with anything to do with market forecasting, only time will tell whether oil has truly bottomed. But a look at the data reveals that the fundamentals of the market will turn; it's just a matter of when.

First, let's put the decline in oil prices in perspective. From a peak of nearly $108 in June 2014 to a low of $26.19, this has been among the two largest continuous declines for oil prices in modern history.

At 76%, the peak-to-trough drop in oil in the last year and a half is only a hair below the 78% decline seen during the financial crisis.

WTI Oil Price

But this downturn has been much more devastating for the industry. That's because prices started at a lower level ($108 compared with $147 before the financial crisis), and also because they've stayed down longer, with OPEC unwilling to cut output this time around due to the threat from U.S. shale producers.

Lowest Price In A Decade

But it's not just the outsized percentage decline that’s signaling that oil is a bargain. At $26, oil is quite simply dirt cheap. It's the lowest nominal price since 2003, and it's even cheaper on an inflation-adjusted basis.

Indexed to 1983 when WTI crude oil futures began trading, prices fell to just above $11 in January, close to the $10 level that has marked the bottom of other large declines throughout history. The one exception is the 1998-1999 period, when oil fell to a record inflation-adjusted low of $6.56.

Inflation-Adjusted Oil Price

Full Storage Concerns Fuel Bears

Of course, none of that is a guarantee that oil won't go lower in the near term. Most analysts acknowledge that prices at these levels are likely unsustainable, but the concern is that, as inventories continue to pile up, there will simply be nowhere left to store excess crude, sending prices to unimaginably low levels.

In this "full storage" scenario, prices would need to fall low enough to spur producers to shut-in existing wells, or in other words, to below the operating cost of pumping the oil out of the ground. That level could be $20, or it could be $15 or lower.

According to Pira Energy Group, onshore crude oil storage may run out by March or April, forcing any excess crude onto tankers offshore.

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