Checking In on Oil's Head-Fake CHARLES HUGH SMITH / Of Two Minds 18sep2008

Checking In on Oil's Head-Fake

CHARLES HUGH SMITH / Of Two Minds 18sep2008

Oil leaped $6 to $97/barrel in the frantic search for repositories of value in an imploding financial doomsday scenario, but this long-term view will be of interest to those looking ahead. Be wary of pronouncements the global markets are now "all better."

Back in May I proposed that oil would plummet in a giant "head fake" which would be followed by a turn-around ascent as Peak Oil struck with a vengence. Since we seem to be in the midst of that head-fake, let's take a long-term look at a few charts of oil, courtesy of frequent contributor Harun I.

Now before we begin, please read the HUGE GIANT BIG FAT DISCLAIMER posted below. This is not investment advice, just some charts and my commentary based on my own limited knowledge.

My thesis is that oil will fall dramatically in a "head fake" which supports a false confidence that peak Oil is far in the future. To the punditry's surprise, supply constraints a.k.a. Peak Oil will reveal the price decline as a "head fake" as oil prices begin a spectacular climb to $300/barrel and up.

To check in on this thesis, I asked frequent contributor Harun I. for some charts which he has graciously provided along with some technical comments. Please note that I have trimmed the charts in size and added comments which are my own interpretation.

"Head Fake"
Global Recession Triggers Oil's Last Decline In Price

There are several fact-based trends which support the "head-fake" scenario. I have covered each of these in more depth in dozens of entries over the past two years.

1. oil supplies are heavily dependent on supergiant fields which are in decline. You can check this for yourself by reading the oildrum sites: Oilwatch Monthly (Europe) - August 2008

The Oil Drum (U.S.)

Knowledgeable correspondent Jose Freitas recently made these very astute and telling comments about Peak Oil and the fantasies that it is a chimera we can ignore:

Missing from nearly all these lists, however, is the simple geological reality that there's only so much oil in the Earth's rocks, we've pumped out most of the really large and easily accessible deposits, and it's becoming increasingly difficult to maintain current production levels – much less increase them – by drawing down the smaller and less accessible deposits that remain. It's not hard to show that this is a major factor in the current energy crisis; when a commodity's price doubles in a year, but the production of the same commodity fails to budge outside of a narrow range, it's a reliable bet that physical limits on the supply of the commodity are to blame.

The difficulties with this otherwise sensible observation, of course, are twofold. It offers no easy answers; if we've reached the physical limits of petroleum production, that's a fact we have to learn to live with, no matter how inconvenient or uncomfortable it may be.

At the same time, it offends against a common assumption of modern thought, the belief that human beings – and only human beings – play an active role in history. Older civilizations understood that nonhuman forces shared in the making of history, and there's a fine irony in the way that our civilization, having rejected the nonhuman world as a historical agent, now finds its own history being shaped by a nonhuman reality with which it steadfastly refuses to come to terms.

2. The Export Land Model reveals that the rising consumption by domestic populations in oil-exporting countries provides a "double whammy" to oil exports: not only is oil set to decline in total production, the amount available to export will be falling even faster.

As just one example, some published accounts suggest that Saudi Arabia will need to burn 1 million barrels a day just to desalinate seawater to serve its populace with fresh water in the amounts they expect. That's 1 MBD that won't get shipped to the West.

3. The cheap oil is gone. All the buzz about "unlimited oil" in shale oil and tar sands breezily fails to note that extracting this oil from such unpromising sources requires stupendous quantities of energy (currently natural gas) and moving horrendously vast quantities of earth, sand, shale, etc.

So the "unlimited" oil ends up costing $80+/barrel before taxes, transportation to markets, wholesale costs and retail profits--not cheap. If the energy needed to extract and refine it shoots higher, then this oil quickly gets ever more expensive.

4. There are physical constraints on all fossil-fuel based fuels. Natural gas is facing its own declines in North America, and it is costly to ship it overseas. Much of the world's natural gas is in the Middle East and Russia. Even at peak production, the shale oil fields of Canada can produce about 2.5 million barrels a day-- not much more than 10% of the U.S. daily consumption.

Ok, on to the charts.

Here are Harun's technical analysis comments:

At the primary level (monthly) there has been 3 consecutive down months. The character of the bars (long bars) and the amplitude of MACD’s major histogram suggest this downturn may have more to go. But there is some evidence that a shorter-term reversal may occur. The confluence of the super-long and long term retrace levels, price support and rapidly converging middle band support may be enough to halt the down move.

At the intermediate level, LT net percent OI (open interest) continues to decline but overall OI has risen. This means that while the number of contracts outstanding has risen, these contracts have been added to the short side which in effect would reduce the net percent of longs. This week LT’s decreased net longs to 194081 down from 197124 while they increased shorts to 131281 up from 122837. The Volume Oscillator continues to indicate a low level of volume.

At the short-term level MACD and r-squared indicate that a bottom may form and price may consolidate or continue in the direction of the primary trend. (Chart not shown.)

Here are a few of my observations.

1. It certainly looks possible that oil will form a "head and shoulders" pattern before the head-fake is done. The 2006 high might be the left shoulder, and the right shoulder might form if oil bounces off the neckline.

2. Alternatively, oil may descend to support levels around $87 or $77 and then stabilize. These are fibonnaci retracement levels, as well as channel support/resistance. (Note that the fibonnaci projections are in two different time frames, hence one in red and one in blue.)

Markets have a way of overshooting to both the upside and downside, so it is also possible that oil will fall to the 61.8% projection around $65--a number often bandied about as a "natural" support level.

A deep global financial meltdown could even cause oil to fall to the "neckline" around $50--a roughly 2/3 decline from its peak.

No one knows where oil will settle--$85, $75, $65 or $50, but regardless of future price action the reality is that the easy-to-get, cheap oil is about gone.

As you do your own research on The Oil Drum websites and elsewhere, pay close attention to how much technology the Saudis must now deploy to keep their production up. It isn't gushing out of the ground any longer folks, and it never will again.