Disclaimer and note: Below my perspectives on this topic. Feel free to incorporate them into your own views but you are responsible for your own investment decisions! I am a novice to financial markets and this blog is a vehicle to help me explore investing so I welcome any feedback.

Topline: I expect there to be a sustained period of low prices for crude throughout 2016, followed by a rise in prices to $55-$65 per barrel before the end of 2017. Moreover, I expect volatility to continue to be exceptionally high in the crude oil market over the next 12-24 months.

If I were to actually place a bet on this situation, given my various external considerations, I would probably make the following moves:

• $25 put on Crude Oil WTI for $1930 (expiration Dec 2017) – in the money if oil prices fall under $23.07[1]
• $50 call on Crude Oil WTI for $5480 (expiration Dec 2017) – in the money if oil prices rise over $55.48

The first is more of a volatility play that I would expect to pay out in 2016 (if at all, of course) while the second is based on the expectation that oil prices will substantially rise by the end of 2017.

Why a sustained period of low prices?

1. Slow ramp-down in US production, plus stuffed channel – EIA predicts that US production will come down 800k bpd but it won’t be completed until Q3 of 2016. Cushing, OK where most US oil is stored, is at record capacity and is literally running out of room.[2] While production will slowly come down, inventory build-up will continue for much of 2016.
2. Ramp-up in Iranian supply – With the lifting of US sanctions, Iran has increased its production by 500k barrels per day and hopes to add another 500k within the next six months.[3] If the Iranians go ahead with the full planned increase, this will more than offset the reduction in US production and continue to build the inventory in the market.

Why a rebound in crude oil prices by end of 2017?

1. US production will have to decline significantly at this price point and it already is: US production will taper off significantly throughout 2016 due to the decline in price of crude. EIA projects that US output will fall by ~800k mn bpd by Q3 of 2016[4], which be about half the excess production as of Q3 2015. The majority of current shale oil wells in the US and Canada will not be profitable at under $65 per barrel[5] (even in the Permian Basin, they need about $40 per barrel to be profitable) – while the marginal cost of continuing to pump these wells may be well under this amount, shale oil wells have shorter life spans (2-4 years) so volume out of existing shale wells will peter out soon and new wells will not be drilled as long as prices stay under $65 per barrel.
2. It’s what OPEC eventually needs: After flushing out North American producers, OPEC will need to bring oil prices back up to a level that is more sustainable for their fiscal budgets. They may choose to target a $55-$65 price point as an acceptable balance between discouraging new drilling in the US and Canada and financing their internal budgetary needs.[6]

Why more volatile than usual?

1. Anticipation vs current conditions – Many market observers believe that oil prices will eventually rebound but they don’t know exactly when. Any piece of news that points to more time working through the oil glut or a faster tightening of the market will cause outsized reactions in the market followed often by corrections. I guess anxiety materializes especially when fear and greed can’t see eye to eye.
2. A lot of moving parts – There are a lot of things that need to move in the same direction for oil prices to rebound. So while people generally feel that they will all point to a rebound in price, any sufficient movement in one dimension could potentially ruin the trajectory.
3. Imperfect information – While there appears to be a lot of information in this industry, it’s not clear how accurate all of it is. For example, this article claims that EIA’s numbers for US oil production is nowhere accurate enough to give a good sense of how much production is decreasing.

Some of the risks to a rebound in crude oil by 2017:

1. Technology: ‘Refracking’ may allow US producers to extract more oil from existing fracking sites at a lower cost,[7] making the current price point of $30-$40 more sustainable. There may also new technology improvements that drive down the cost of new wells that are currently unforseen.
2. Lack of production controls between Saudis, Russia and Iran: In this scenario, Iran production continues to ramp up more quickly than expected and the three largest producers outside of the US cannot sufficiently coordinate on production. This seems like a non-trivial risk given the histories between all three parties in the past.
3. Deflation risk: If consumers choose to save more of what they gain in lower gas prices than spend it, it increases the risk that countries may tip over into deflation – a real concern given that the US, Japan, and EU countries are already experiencing tepid growth, very low inflation and their policymakers running are out of tools to support a healthy mild inflation. This may in turn dampen consumption, leading to a drag on oil prices.
4. China’s economic slowdown is more severe than expected: Even with China’s slowdown, EIA expects a modest continued increase in oil consumption[8]. While it is possible that China’s economy may slow down more than expected, low oil prices should provide some positive push on volume.

Observations and questions that are not immediately relevant to this but still interesting:

• Fracking, with its shorter lag times (from observation of price to decision to invest to oil production), may result in less volatile oil prices in the medium term. Moreover, it is easier and faster to re-start a mothballed fracking site than it is to restart a traditional vertical well[9]
• Siluria is one potentially game-changing company to watch out for as it looks promising that they will be able to turn methane and other natural gas products into oil more easily. [10] At 2014 natural gas prices, they were estimating that at scale they would be able to produce one gallon of gasoline for $1.
• What is the effect of Paris climate change talks?
• What is the long-term view of oil? When do we expect to ‘run out’? Are we on pace to replace oil by then?
• Are the Saudis taking an unnecessary hit to ‘flush out’ shale oil producers when they will be able to bounce right back when the price comes back above $65? Overall, are they facing a radical reframing of the oil industry, the end of fat oil revenues before they expected it to end?

Other reading and resources:

http://www.vox.com/2016/1/12/10755754/crude-oil-prices-falling

http://www.ft.com/cms/s/2/3f5e4914-8490-11e4-ba4f-00144feabdc0.html#axzz3M0pu7m13 (great graphic on differential impact of oil prices by country)

http://phx.corporate-ir.net/phoenix.zhtml?c=79687&p=irol-reportsother (SHOWS NUMBER OF RIGS IN US AND CANADA)

http://www.macrotrends.net/1369/crude-oil-price-history-chart

[1] Prices from http://www.barchart.com/commodityfutures/Crude_Oil_WTI_Futures/options/CLZ17?mode=i&view=

[2] http://money.cnn.com/2016/02/04/investing/oil-prices-space-us-inventories-supply-glut/

[3] http://www.bloomberg.com/news/articles/2016-01-18/iran-gives-order-to-boost-crude-oil-output-amid-global-glut

[4] http://www.forbes.com/sites/arthurberman/2016/02/10/opec-production-cut-unlikely-until-u-s-production-declines-another-million-barrels-per-day/#4d847ae05739

[5] http://fortune.com/2015/01/09/oil-prices-shale-fracking/

[6] End of 2014 Vox article (http://www.vox.com/2014/12/16/7401705/oil-prices-falling) quotes analysis showing that Saudi Arabia needs an average oil price of $85 to meet its fiscal budget. It also says elsewhere in the article that at $60 price point, in 2015 they will run a fiscal deficit of 14% of GDP. More recent analysis showed that 2015 budget deficit was 16% of GDP despite a average ~$50 price point throughout 2015. This translates to  ~US$97bn against a foreign reserve of ~$750bn, which gives it about a 5-6 year runway (they also have the option of issuing bonds and going into debt). To make a continuing price of $60 sustainable, Saudis will have to reduce their fiscal budget by nearly 40% (e.g., 2015 budget was 965bn riyals with a deficit of 367bn riyals)! Is this possible for the Saudis? Perhaps, as as 215bn riyals alone are dedicated to military spending in 2015 (presumably funding the fights in neighboring countries).

[7] http://www.bloomberg.com/news/articles/2015-07-06/refracking-fever-sweeps-across-shale-industry-after-oil-collapse

[8] https://www.eia.gov/forecasts/steo/tables/?tableNumber=30#startcode=1997

[9] http://www.bloomberg.com/bw/articles/2013-10-10/u-dot-s-dot-shale-oil-boom-may-not-last-as-fracking-wells-lack-staying-power

[10] http://www.sfgate.com/business/article/Natural-gas-to-1-gasoline-5701521.php