Tue, Feb 16, 2016|Justin Brill

Big News on Oil

Big news on oil... Saudi Arabia and Russia make a deal... A 'false dawn' in oil... 'Every tank and swimming pool in the world is going to fill'... The next big 'bust'...

Today, we woke up to surprising news from the oil sector...

At a meeting in Doha, Qatar this morning, OPEC leader Saudi Arabia and Russia – the world's No. 1 and 2 oil producers – announced a preliminary agreement to "freeze" oil production at January's levels. The agreement also included smaller OPEC members Venezuela and Qatar.

While it includes only four of the top 17 global producers, it would potentially involve a huge chunk of the world's oil production...

Saudi Arabia and Russia each produce more than 10 million barrels of crude oil per day. To put that in perspective, outside the U.S. – which produces about 9 million barrels per day – no other country in the world produces even half that much. And 11 of the top 17 produce fewer than 3 million barrels per day.

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Given the news, you might expect to hear that oil prices soared today. But you would be wrong...

Oil did rally as much as 5% when news of the meeting broke... but prices reversed and plunged more than 1% when the details of the agreement were announced.

There are a couple potential reasons for this...

First, even if the deal is finalized, it means the world's two biggest oil producers will simply be maintaining January's record production levels. That's much different from an agreement to cut production.

While it would be a long-term positive, in the near term it would do little to correct the major problem keeping prices low today: the huge glut in oil supply.

Second, there are plenty of reasons to doubt the agreement will hold...

Russia agreed to the deal with a caveat, and it's a big one: OPEC members Iraq and Iran must also agree to freeze production. And that appears unlikely.

Iraq has increased its production to record levels to fund its fight against ISIS.

At the same time, Iran is increasing its production as quickly as possible now that U.S. sanctions have been lifted. According to the Wall Street Journal, Iranian officials have said they won't even consider slowing production until its output returns to pre-sanction levels. At the current production rate of 400,000 barrels per day, that means Iran could add another 1 million barrels per day to the global oil markets.

But it's not just Iraq and Iran...

History suggests even the four countries already involved in the agreement may not hold up their ends of the deal.

For example, Saudi Arabia and other OPEC nations have routinely produced more oil than they've officially agreed to... and those agreements were within OPEC itself.

In addition, Saudi Arabia has been "burned" by Russia before... According to the Journal, during previous oil-price downturns in 2001 and 2008, Russia promised to cut production, but instead increased it when Saudi Arabia cut.

Of course, we wouldn't rule anything out at this point...

Just seeing Saudi Arabia agree to meet with Russia again is remarkable. It's a sign that this game of "chicken" isn't just hurting U.S. shale producers... it's also hurting Saudi Arabia and other OPEC producers, too.

If prices stay low, OPEC could eventually become desperate... and there's no telling what desperate governments might do.

Still, we think any major coordinated actions between OPEC and other producers are unlikely any time soon. In the meantime, the supply glut continues to get even bigger...

In its latest monthly report published last week, the International Energy Agency ("IEA") said the recent bounce in oil prices was likely a "false dawn." Incredibly, it said supplies were growing even faster than it believed last month, when it predicted the "oil market could drown in oversupply" in 2016.

Like us, the IEA believes a near-term deal between oil producers is unlikely. In addition, it notes there is little evidence that lower prices are leading to increased demand (the other factor that could lead to higher prices)... and the long-predicted decline in U.S. shale production is taking much longer to happen than predicted.

It said global oil supplies were likely to increase by 2 million barrels per day in the first quarter of 2016, 1.5 million barrels per day in the second quarter, and even more in the second half of the year...

We suggest that the surplus of supply over demand in the early part of 2016 is even greater than we said in last month's oil market report. If these numbers prove to be accurate, and with the market already awash in oil, it is very hard to see how oil prices can rise significantly in the short term. In these conditions the short-term risk to the downside has increased.

The situation has gotten so bad that Robert Dudley, CEO of oil giant BP, recently predicted the world's storage capacity would be completely maxed out by the second half of the year. Speaking at a conference last week, Dudley said...

We are very bearish for the first half of the year. In the second half, every tank and swimming pool in the world is going to fill and fundamentals are going to kick in. The market will start balancing in the second half of this year.

In other words, companies and countries are unlikely to cut back on production until they can't sell another barrel. And that means prices could head even lower in the meantime.

Just how low could prices fall?

According to Goldman Sachs' head of commodities research Jeff Currie, prices below $20 per barrel are now likely. As he explained in a recent interview with Bloomberg...

Once you breach storage capacity, prices have to spike below cash costs because you have to shut in production almost immediately... [I] wouldn't be surprised if this market goes into the teens.

West Texas Intermediate crude oil – the U.S. benchmark for prices – is trading near $29 today. That would represent another decline of 30% or more from here.

Dramatic new lows in oil would mean even more pain for oil producers and related industries, but it's unlikely to end there...

Troubles have already spread from shale producers to offshore oil producers to oil services, shippers, and retailers. Porter predicts the next big "bust" will come from the financial side. As he wrote in the January 29 Digest...

Somewhere out there, right now, there's a firm that's been speculating on energy prices. No one suspects it's in trouble today because it has been hiding the losses... doubling down... praying for a bounce in energy so that it can escape. I don't know which firm it is... but I know it's out there somewhere.

The point is, these problems are going to be transmitted through financial firms, through cross-holdings, and through credit ratings and losses. This isn't a mere correction to stock prices. Stock prices weren't that inflated. This is creative destruction on a massive scale. And it's hitting a world economy that's more brittle than ever, thanks to huge concentrations of wealth and the accumulation of more debt than the world has ever seen. It's not going to be pretty.

The recent declines in banks in the U.S. and Europe could be just the first signs of what's to come.

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In today's mailbag, a happy subscriber shares his experience... and a novice investor asks for help. What's on your mind? Send your notes to feedback@stansberryresearch.com.

A relatively new subscriber shares his experience with Stansberry Research. What's on your mind? Send your notes to feedback@stansberryresearch.com.

"I thought I was supposed to sleep well at night following Stansberry recommendations! Instead, I find it hard to fall asleep. And if I do, I find that I wake up during the night and can't fall back to sleep! And it's all because... I'M SO EXCITED that I FINALLY have a grasp on what I'm doing in the market - and really have been kickin' butt!!

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"As an example, the Santander short recommendation. I bought the longest-dated puts available (Jan 2017) with a strike price of 12.50 on 12/17 at $1.40. I kept my position size (one thing Stansberry drives home - and I have taken to heart) to less than 1% of my portfolio, so even if the options expire worthless, I am risking no more than if I shorted the stock and used a 25% trailing stop. Today they're worth $3.70 for a 161% gain (1014% annualized, not assuming compounding), which I couldn't do shorting the stock (max 100% gain - if the company folds), and don't have the possibility of 'infinite' loss (if I don't stick to my stops - a historical issue with me). Similar plays on HYG and COF are working almost as well. (A similar play on C started off magnificently well, but is back to being under water [all within days], but I don't expect that to last...)

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"I thank you for all the information you provide but I don't understand any of it. I wish I did, I don't know who to buy from, nor how to buy stocks nor how to take advantage of the opportunities you provide to me, wish I did but I don't so I cannot respond. If you wish me to come on board, please provide me with an explanation on how to. Thanks." – Paid-up subscriber Sharon B.

Brill comment: Sharon, as Porter often says, "There is no teaching... only learning." Ultimately, you and you alone are responsible for your financial future. But if you're willing to learn, we can help...

Our two books for novice investors – The Stansberry Research Starter's Guide for New Investors and The Stansberry Research Guide to Investment Basics – are a great place to start.

As a "paid-up" Stansberry Research subscriber, you already have access to these books at absolutely no cost. You'll find links to these books at the bottom of the welcome letter that comes with each of your subscriptions. (You can access them 24/7 by logging into your paid account on the Stansberry Research homepage right here.)

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Regards,

Justin Brill
Baltimore, Maryland
February 16, 2016

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