Crude Oil Still Intent on Cracking the $50 Per Barrel Level

As we write this, crude oil continues it crash, seemingly intent on cracking the $50 per barrel level. The early- 2007 weakness in the energy sector has surprised nearly everyone – ourselves included. Yet when viewed in the sharp light of hindsight it makes complete sense. The warm El Nino winter and subsequent larger-than-expected inventories have certainly impacted the market but the essential reason behind the sell off in crude oil may be political.

Both Saudi Arabia and the US have a vested interesting keeping the price of crude oil low for now. For America, the reasons are obvious; cheaper crude means a stronger economy and less upward pressure on prices. Considering that energy is one of the larger expenses for a fighting force, cheaper crude also means a cheaper Iraq war. Cheap crude also hits US nemeses Iran and Venezuela in their pocketbooks, right where it hurts the most.

This is where Saudi and American interests converge. The Sunni world is terrified of the rising Shiite power represented by Iran. Starving the latter of petrodollars (or in Iran's case petroeuros) is in Saudi Arabia's best interests. Condi Rice's trip the Mideast is about garnering support of the Sunni Arabs against Iran. Yesterday Saudi Oil Minister Ali Naimi was reported as saying no new emergency OPEC meeting was needed to combat low prices.   Could this be the latest phase of a US / Saudi deal which brokers continued American presence in Iraq – and perhaps the troop "surge" we've all been reading about -- for lower crude oil prices? Stranger things have happened.

Saudi Arabia has another reason to keep prices temporarily low; alternative energy sources become less viable at low prices. $50 per barrel is the cutoff for a number of solar technologies. Oil sands begin to become unprofitable under $40 per barrel. (If you are wondering why the Canadian dollar has been getting hammered lately, wonder no further.) Domestic deep-water drilling is more of a gamble when the average selling price for crude oil falls. Bottom Line:  Lower oil prices may hurt Saudi revenues today, but they also work to increase the time the US remains dependent on Mideast oil and by extension, the Saudis. However, that doesn't mean crude oil will remain mired at these levels forever.

The last time oil experienced a sell-off of this magnitude was in 2003, immediately following the invasion of Iraq. The "successful" US invasion was supposed to ensure plentiful oil and prices dutifully crashed 60% once the Iraqi army was defeated. The current bull market began nine weeks later. 2003 was also the last time the US had two carrier groups stationed in the Persian Gulf. With another carrier group steaming toward the Gulf now, the potential for a widening of the Iraq War grows. All it would take is one Chinese-made, Iranian missile striking one American ship.

Barring a geopolitical event or a major supply disruption, the near-term outlook for crude oil looks bleak. However, long time traders know it is generally darkest just before the dawn. When oil prices finally turn up again, they could do so in a hurry – especially if today's low prices cause capital to stop flowing into alternative energy sources. The bloodied commodity funds are now heavily short, adding fuel to a potential short-covering rally which could begin at any time. Will this rally occur in time to save our underwater bullish option spreads?  We don't know. However this is why we use options. We can expose our portfolio to the upside of the energy complex without betting the farm.

Crude could stay weak for a little while longer, but we do not think these prices will last. Like it or not, the world is still running out of cheap oil. Triple-digit crude is still in the cards. The question is when. OE believes we could very close to an important buying opportunity and is seriously considering using this sell-off to establish long term bullish positions using December 2008 call options. All we are waiting for is a sign of strength – something we could get as early as this week.

As we mentioned earlier, yesterday's selloff in the black, sticky stuff was due largely to Saudi oil minister Ali Naimi's statement that he saw no pressing need for an emergency OPEC meeting. As OPEC's swing producer, Saudi Arabia calls the tune. Its rejection of a meeting is a direct slap in the face to fellow OPEC member Iran.  It is about as bearish a turn of events as this market has seen. A rally this week could be a sign of a bottom, much as crude's failure to rally on the bullish announcement of a 400,000 barrel-per-day shut down in the Alaska pipeline signaled the top.

Steve Belmont
for The Daily Reckoning Australia

Steve Belmont is a partner in the RMB Group in Chicago, Illinois USA.

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• Crude Oil: A Long Term Forecast
• When Big Oil Buys Out the Big Diggers
• Chart of the Day: Crude (USO) Hits Long-Term Support at US$47.50

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