Wednesday, July 1, 2015

Is Oil About to Drop Massively?

By all accounts there is simply too much oil being produced right now and its showing up everywhere. Saudi Arabia is pumping barrels like there is no tomorrow, Qatar is doing the same, Iraq has raised its production and most importantly Iran could be shipping globally again any moment.

Iran is currently in talks with the US, Britain, France, Germany, Russia and China negotiating a deal to lift sanctions. For a quick primer on the Iran nuclear talks click here. The U.S. Energy Information Administration estimates that oil exports in Iran have plummeted from 2.4 million barrels a day in 2011 to 1 million barrels per day currently.

Some oil analysts believe that it will take awhile for sanctions to fully lift and for Iran to ramp their production back up. Our belief is that even a minor ramp up in production and exports will move oil prices dramatically.

Our rationale is that there are other macro factors at play that will hurt oil prices. The biggest in our opinion is a slow down in China's economy. China's stock market bubble has popped and despite multiple stimulus interventions in the last few weeks by the PBOC, China's market is as fragile as its been in decades.

Here is the price of oil since the mid 90's.

We believe that oil will at a minimum retest the lows last seen during the great financial crisis in 2009.

For our friends and clients in Brazil this would add more pressure to an already weak exchange rate. Here's the price of oil (blue) compared to BRLUSD (red).  The Colombian peso and Russian ruble would also be significantly impacted by another large move down in oil. There's lots of interesting trades developing around these themes. You have oil to trade, FX rates, Chinese equities, Canadian and U.S. debt/equities on oil companies. Lot's of ways to mix match.

While not a trade or investment recommendation we have our eyes on a long COP/CAD trade after a big move down in oil. We believe that Colombia's currency has been oversold due to a faulty market perception which over-correlates Colombia's currency to oil prices. Colombia's economy has many other things going for it beyond oil production and exportation. Furthermore we believe that Canada will be entering a recession shortly. Canada has been in a gigantic real estate bubble for a number of years and it will pop just like any other asset bubble. It does not hurt that this trade possesses a nice positive carry of approx 3.75% before applying any leverage.

In the chart below you can see the Colombian peso (green) vs the Canadian dollar (purple). We'd like to see these spread a part a bit further to reach maximum attractiveness. Anyway you get the point. There's lot's of strategies that are all far more interesting than the usual long only approach of just holding a mix of stocks and bonds.

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