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Prepared by Philip Gotthelf

Crude Oil Transition

(July 28, 2016) On April 30, 2008 CNN covered former president Bill Clinton's remarks that, "I [he] would be very surprised if oil goes below $100/bbl again in my lifetime." Well, SURPRISE! That month crude oil reached a $119.93/bbl high. By July, 2008, it soared to $147.27/bbl. However, by yearend, crude crashed to a $32.40/bbl low.

How's that for a presidential prediction? Of all the major economic sectors, energy has experienced the most technological and structural disruption. While fracking holds the spotlight, I have reported on a wide variety of other game-changing innovations that include horizontal drilling, geo-magnetic surveying, deep-shaft technology, and oil sand processing. More oil resources have been discovered in the past fifteen years than in the previous fifty.

Unquestionably, technological advances in discovery and exploitation account for a great deal of the oil evolution. However, eco-political influences are as significant… if not more important in determining near-term market dynamics.

The Arab Spring rapidly disrupted the entire Middle East, but structural changes were already well underway before the Tunisia transition and the Egyptian roller-coaster. I wrote about his in 2008 before the huge price surge when I pointed out that the Jack 2 test well in the Gulf of Mexico increased U.S. projected oil reserves by 50%.

Even as crude raced toward $150/bbl, I warned that Bill Clinton's assessment was wrong. Even Goldman Sachs predicted prices over $200/bbl before the end of the first decade. Within six years, global reserves had more than tripled. I issued another REPORT that reviewed areas that were and are not even in the news. Colombia is rapidly emerging as a significant producer. New wells in the South China Sea are beginning to produce. Prospects off the Greenland coast hold enormous potential and there is even the probability of massive reserves in the Bermuda Triangle.

I wrote about progress in lowering shale oil costs as prices began to slide. To be sure, I received a skeptical response from industry people who said costs were more likely to rise than decline. Their logic was sound, but lacked perspective. I have been involved in the oil sector since the Oil Embargo of 1973.

In fact, I developed tertiary oil recovery technology using ultrasound in the early 1980s. I know how quickly technology adapts to changing economics. Indeed, the Wall Street Journal July 14, 2016 "Business News" carried an article by Selina Williams entitled "Shale Drillers Adapt to Low Prices." The article cites energy consultants Wood Mackenzie who reports that shale oil is the majority of the 9 million barrels per day of "new" production. Even with Brent crude at $60/bbl or less over the last year, production has increased by 1.5 million barrels per day. Current output is higher than at any point since 2009. This is a significant revelation.

Mackenzie goes on to say that ultra-deep-water wells like those in Angola and Nigeria are not viable with crude below $60/bbl. I disagree with their assessment because the capital costs are front-loaded for most of these very expensive projects.

Like any technology disruption, it takes time for new methodologies to settle into a state of equilibrium. Typically, high prices bring a surge in development and deployment followed by declining prices and a need for greater efficiency.

Interestingly, some of the environmental concerns and pressures have led to greater efficiencies and economies of scale. Addressing environmental concerns has led to innovative "thrifting" in water use and chemicals.

The attraction to the growing blue collar labor market has brought down wages for further savings. High volume rig assembly has lowered equipment costs. All these transitions are quickly taking place despite recent crude oil weakness.

It is important to keep my perspective in mind when sorting through main stream financial media. Every so often, you will catch an article in publications like The Wall Street Journal (WSJ) that address the reality that low oil prices do not correlate to a slowdown in production. In addition to Ms. William's shale drilling article, she co-wrote "Saudis Tap Into Their Oil Stockpile" with Summer Said. In that piece, attention is given to surging domestic demand and the need for foreign revenues. The Saudi stockpile has been drawn down by 12% since October, 2015 and has undergone the longest sustained dip in fifteen years.

Again, the article is many months behind my coverage where I pointed out that Iran's reentry into the world market would cause a pumping war. Not only has technology changed… we see a structural transition in the entire global market. We are no longer talking about decades or even years of development and transition. We are talking about months!

Energy Policy

Let's be clear. The U.S. does not have an energy policy. The lines between Democrats and Republicans have been drawn by nonsensical rhetoric. As the Democratic National Convention concludes this week, we hear that Climate Change is the number one threat… far exceeding terrorism. This is a platform position rather than an energy policy. In truth, Democrat politicians have done more to promote fossil fuels than their rhetoric suggests. Both parties must be exceptionally careful not to disrupt expansion of U.S. energy production when considering the economic benefits of lower energy costs for consumers and the number of jobs at stake. So, talk is cheap, but don't believe the political posturing.

To be sure, the Obama Administration has waged war on coal with devastating consequences in our major coal regions. If Hillary is elected, this war will wage on. Hillary will also be forced to curb Big Oil and the shale movement. This is because the Democrat platform demands Climate Change action. The impact upon the crude oil transition will be swift and substantial. U.S. energy policy could shift oil dominance back to other sovereign producers… particularly within the Middle East.

This poses a huge problem for a Hillary Administration. If states like Iran, Syria, and Libya are empowered by rising oil prices and supply dominance, terrorism will gain unimaginable capabilities. The lack of control over rouges like North Korea and the potential for further radicalization of nuclear powers like Pakistan and even Turkey could "commoditize" nuclear weapons. Everyone will want to go nuclear and all it will take is cash.

For all the Trump enthusiasts, the situation is not necessarily better. First, the Hillary machine is far more formidable than the Republican primary contenders. The continuing "Never Trump" foolishness within the "establishment" only serves to enhance Hillary's likelihood of being our first female president. Trump has no energy policy. His only potential advantage is viewed by the media as an anti-Trump talking point… his potential alliance with Putin. I cannot give Trump credit for anything, yet. However, Russia has a strong interest in maintaining its position as a major crude oil supplier. Russia needs U.S. cooperation to avoid an allout pumping frenzy.

Putin would prefer to negotiate a "deal." But, if it's not Trump, Putin is counting on Hillary's Climate Change platform to curb U.S. fossil fuel competition. So, Vladimir isn't really that concerned… even if Russia hacked the DNC emails! From Russia's perspective it is important to maintain the symbiotic relationship with Western Europe for natural gas and crude oil. Putin is an acclaimed businessman and superb negotiator. Our news media only portrays him as a ruthless former KGB quasi dictator. The entire world community faces challenges resulting from the crude oil transition.

Putin is actively formulating Russian energy policy because he is unencumbered by a Congress and could not care less about Climate Change, whether it is real or not.

Twenty years ago, Energy policy focused upon strategic reserves and defensive mechanisms for dealing with OPEC. Today, global strategic reserves represent an overhang and very expensive inventory accumulation.

Speculators are storing oil in tankers, hoping for a sufficient price recovery to exit positions with a whole skin… or, even a partial skin. This situation will take months, if not years to "normalize."

This brings me to the question of normalization. If you are a free market advocate, we must allow the disruption scenario to play out. In other words, fracking, horizontal drilling, deep shaft drilling, exploration, tar sands, and all other methods of gathering fossil fuel energy resources must run their course to allow the market to settle into a "new age" price band. Marginal technologies will be sacrificed and economically feasible sources will determine average prices… absent political influences.

Technical Picture

Even with a bullish natural gas report, September crude oil was down 50¢ by midday today (Thursday). The chart displays a clear and symmetrical rounded top with support at 4500. This was breached and the chart projects to a 4000 first objective. This is occurring after the consensus was for a continuing rise in crude.

This is a very orderly formation, suggesting continuing bearish pressures are slowly and steadily growing. The chart is not reactionary. Rather, it is trend worthy. Let's put this current action into historical perspective.

The monthly continuation chart shows crude prices have dipped into the first trading range band established from 2000 into 2004. How does this relate to fundamentals? If you track Energy Information Administration (EIA) numbers, the rate of consumption growth has proportionately slowed while the rate in proportional production growth has expanded. This implies that the current price is fundamentally justified.

The huge spike from 2007 into 2008 raises the question, "Why?" Examine production and consumption for the period. Nothing fundamentally occurred to support such a massive inflation. We know it was speculation. This is ever more evident when considering the 2008/09 plunge below $35/bbl. What changed? Obviously, the Financial Crisis intervened. But, China was not buying up and consuming all the oil.

Over the last ten years average vehicle fleet mileage has improved. There are more hybrids on the road representing 15% to 50% gains in miles per gallon. My new Toyota Prius consistently delivers more than 50mpg. Prius hybrids are like opinions… everyone seems to have one. Gas water heaters and furnaces are up to 90% efficient. Jet wing designs have reduced drag by a whopping 40%. Airbus A319 and A320 jets use small upper and lower winglets while larger long-haul twin-engine A330, four-engine A340, and Boeing 747-400 have more conventional attached or augmented winglets for major fuel savings.

Unless there is an eco-political dislocation, there is nothing to suggest crude will return to lofty levels above $100/bbl. I can see pops to $80/bbl and dips to $25/bbl, but the prospect for another 2007/08 is not on the immediate horizon. For the moment, there is considerable speculative oil being stored in various unreported locations that needs to be sold to avoid storage charges. Seasonally, I believe we are approaching the pressure point where oil inventory must be moved to make room for new. Without a boost in consumption, this old supply will require sacrifice.

The Green Movement is a disruptive force for fossil fuels. The Hillary platform represents a dangerous threat to stability in the oil patch. For Green advocates, this appears to be a good thing. For booming economies in fracking states including Ohio, curbing the oil revolution is tantamount to curbing economic growth and prosperity. Not political, just a fact.

July 28, 2016
Philip Gotthelf
Commodity Futures Forecast
P.O. Box 566, Closter, New Jersey

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