Oil Prices Race Toward $20

Energy

Published: January 6, 2015 6:55 am

Weeks ago, oil priced at less than $50 a barrel was unimaginable. Today, a price of $20 draws the same immense skepticism. However, there are some justifications for oil prices to fall another 50%.

The first case for oil dropping into the $20s is the direction in which some smart money is betting. According to William Watts, writing at MarketWatch about oil expert Stephen Schork:

Here’s where it gets interesting: Open interest on $30 puts on the March futures contract CLH5, -2.61% rose to 2,127 from 34, while $30 puts on the June contract CLM5, -2.31% rose from 35 to 51,252. In addition, there has even been some light trading in June $20 puts, with open interest at 176 as of Friday’s close.

The beliefs behind the trades are likely based on the same reasons for the recent collapse of oil prices. Supply is plentiful. The economies (and almost certainly the demand) of Japan and Europe have stalled again. The Saudis show no sign of blinking in a supply war against U.S. frackers. Oil-rich countries, including Russia and Venezuela, continue to produce and ship oil because they need the money. Even if producers in these countries (and the governments) are losing money, better to have some flow of revenue than no revenue at all.

Another critical theory about future oil prices is that the largest oil companies will not drop production sharply. They need to support production infrastructures that have cost tens of billions of dollars to establish. However, while these companies have the balance sheets to keep pumping, those same balance sheets allow them to idle some wells, taking them out of production. So, the big oil theory has only modest support as a means to pressure oil prices lower.

It will not take much in terms of news about sharp increases in supply from major producers, or evidence of sharply sliding demand, to almost certainly push oil prices closer to $40. Some smart money believes the price will go much lower. Smart money that bet on the recent sell-off did very well.

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