Why Oil Is Going to Zero.

Every trader in the oil market is fascinated by the recent price action. The last few months have seen an onslaught of negative news developments that should have sent the price of Texas tea to the moon. Instead, it has fallen, from a high of $110 in February to as low as $84 last week. What gives

Investors can be forgiving for thinking that oil should be printing $150/barrel here. It has been nearly six months now that the Iran oil embargo was expanded from the US to include Europe. The Islamic nation is now producing 1 million barrels less a day than it was a year ago.

Yemen, Syria, Sudan, and Kazakhstan are all offline here for a variety of political reasons. While with all small exporters, there was a day when the loss of even the tiniest incremental producer sparked a frenzy in the oil pits. Now we see hundreds of missiles raining down on Gaza and a further booster to the geopolitical bid for oil.

The normal explanation is that the market is anticipating that the economy will plunge into a headlong recession in 2013. But the economic data is not indicating that anything like that is on the immediate horizon. To find an accurate explanation we will have to delve deeper into the black commodity’s long-term fundamentals.

Saudi Arabia has been the major factor, offsetting OPEC production elsewhere with increased production of its own. The kingdom is now pumping 11.5 million barrels a day, an all-time high, and is thought to have another 1 million barrels a day in standby production.

Libya has restored its own production to pre-civil war levels of 1.5 million barrels a day. It turns out that both sides in the conflict protected the pumping facilities because they thought they would win, hence their rapid return to the market.

Some in the industry blame president Obama for slack prices. First, there was his jawboning about oil speculators in the spring, which prompted the CME to raise margin requirements for all commodities. There is no way that he was going to let high gasoline prices pee on his election parade this year.

Also important is that the US Strategic Petroleum Reserve is full at 739 million barrels, so there will be no incremental buying by the government. With the US headed for energy independence in the near future and about to become the world’s largest exporter, there is in fact, no longer any need for an SPR. That would bring an end to lavish political pork payments for the storing states of Louisiana and Texas, which overwhelming voted red in November.

China has completed the first 110 million barrels of purchases for its own Strategic Petroleum Reserve. It will add another 400 million barrels by 2020.

It is clear that high oil prices are curing high prices. Oil hit a bottom of $10 a barrel in 1998, when it was worth less than the barrel holding it. That is when the industry obtained its last raft of tax subsidies from Washington. After that, it rocketed to $149. The big guess is how close we get to the last bottom. If world peace breaks out — a distinct possibility if Iran folds its nuclear program in response to unremitting US pressure — then oil could lose a risk premium that many in the industry estimate at $30-$40/barrel.

One certainty is that the next downturn could be much more exciting than the last. The arrival of ETF’s mean the public now has much greater capacity to sell oil short, substantially increasing volatility in the next selloff.

Chinese government officials recently told me that in the 2020’s the US will be the next China, thanks to a huge cost advantage afforded by cheaper energy. Given the recent price action. That could happen much sooner than they think.

Use every substantial rally to sell oil short, or buy puts on the United States Oil Fund ETF (USO).

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