Oil producers and investors started to breathe a little easier recently.
Crude oil prices touched their lowest closing level in six years last week, then rallied on the back of a weakening U.S. dollar.
Many optimists are expecting oil prices to continue to rise. But that’s just wishful thinking.
You see, I’m in Hong Kong right now, and my contacts have revealed some startling facts…
The Catastrophic Reality
The truth is, we may be on the verge of another price collapse that’s likely to occur in the second quarter.
Inventories are continuing to rise, and storage tanks are close to capacity. With nowhere for the oil to go, suppliers will likely flood the market, which could cause a plunge in prices that will force the industry to lower production.
That will be the point of capitulation.
This might seem like an outrageous prediction, but the chance of such a scenario taking place isn’t far-fetched when you consider the factors that may precipitate such an event.
Inventories can only climb if one of two things are occurring: Either less oil is being consumed or too much is being produced.
Well, both of these factors are at play concurrently right now.
The latest figures coming out of Cushing, Oklahoma show that capacity is between 60% and 75%. Early last year, the daily figures were half that.
At the current rate of production and consumption, capacity is estimated to be reached by the end of May.
Smaller producers are making the situation more difficult by producing even more in an effort to try to capture hedges while premiums still exist. Hedges can be put on for 2016 at premiums of up to $10 more than current spot prices. And when you have debt to service, any increase in projected cash flows is critical.
To further exacerbate the situation, oil is priced in dollars. And as the dollar strengthens, the price weakens.
There is also a wildcard that could spur a short-term rise in prices. Rebels have toppled Yemen’s government and Saudi Arabia started employing defense tactics. Yemen’s proximity to Saudi Arabia could be perceived as a threat to oil production, sparking a temporary rise in demand and prices.
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But the insider story that could fill storage to capacity comes from 8,000 miles away in China…
The Last Straw
My sources in Hong Kong, who are connected to major players on the mainland, are indicating that the slowdown in China may be even greater than the official numbers.
China’s “official” growth rate fell to 7.4% in 2014, the lowest in 25 years. But other sources are saying it will be lower.
The International Monetary Fund is projecting growth to come in at 6.8% in 2014. Analysts from Oxford Economics, a well-respected consulting firm that covers global markets with the likes of Accenture (ACN), are calling for growth to come in at 6%.
China’s own economic leadership estimates that growth must be at least 7% to maintain adequate employment for a growing work force. I’m sure the official numbers from China will be above 7%, but those numbers shouldn’t be trusted.
As China’s economy slows, the country will demand less oil. The resulting excess oil could fill storage tanks to capacity.
That will be the point of capitulation, which provides excellent entry points across the investing spectrum.
As we all know, the Organization of Petroleum Exporting Countries (OPEC) could provide some relief for prices if it culled production. But just a few days ago, OPEC reiterated its goal of continuing to produce at current levels until another country curtails production first.
Saudi Arabia seems firm in its plan and is not open to negotiating. Last week, the Algerians tried to convene a summit to discuss prices… but only Angola showed up. Last month, the Nigerians wanted a meeting of OPEC members, but the idea was squashed by the Saudis.
Everyone is feeling the pain, but we’re not yet at the point where the pain is significant enough to spur the major players into action. When the price begins to trade south of $40 for a sustained period, we may start to see movement to curtail production globally.
The risk to oil prices is still tilted to the downside, and investors should be keeping their powder dry at this point.
And the chase continues,