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OPEC to US oil producers - "You'll break before we do."...

Clive Maund
December 1st, 2014

OPEC's decision yesterday not to cut production has "thrown down the gauntlet" to US oil producers. Due to booming output in the US there is now a global glut, and OPEC has just made it clear that they are not going to be the ones to make all the necessary sacrifices to hold the price up, especially as by doing so they would be assisting the forces that creating the glut in the first place.

Most traditional oil producers, especially those in the Mid-East can still make a profit at prices much lower than they are now. The same is not the case with the US producers, which are high cost oil shale or fracking operations.

You've all seen the situation where a big chain store opens up an outlet in a new area, and then sets about eliminating the competition by charging very low prices. For a while the new outlet runs at a loss, but attracts customers away from the other local stores, which have sometimes been there for decades, and drives them out of business. The big chain can afford to do this because it has deep pockets. Once it has wiped out the competition it jacks up prices, and has a captive market - the customers of the businesses it has killed off.

This is what OPEC clearly plans to do to the US oil industry. It will allow the oil price to collapse and stay down for long enough to decimate the high-cost US producers, leaving only a core of survivors like those operating the Bakken. Once they have shredded the US industry, they can tighten supply again and drive prices back up. This strategy is of course not entirely painless for OPEC, and will involve sacrifices - for example, the Saudi oil sheiks may defer updating their personal fleets of Ferraris, Lamborghinis and Rolls Royces for a year or so, making do with being chauffeured around in luxury cars that are as much as a year or more old.

The implications of what happened yesterday, when many Americans were feasting on turkey, are HUGE. The key point to understand is that OPEC is out the smash the competition, and for this reason they are happy to precipitate a plunge and ready to tolerate the adverse impact of sustained low oil prices for a long time to come. What this means is that the oil price is likely to drop a lot lower yet and stay depressed for quite a long time - long enough to finish off most high cost US producers. Once they have achieved this objective they will tighten supply again. The only thing that could derail their crafty plan would be the US government stepping in to heavily subsidize the US oil industry, which would of course require countless billions of dollars. As traders, this is something we need to be on the lookout for. Otherwise yesterday's action looks like the "starting gun" for a brutal phase of the oil bearmarket. Weak demand in places where deflationary forces are rampant, like Europe, is another factor depressing the price.

What do the charts have to say? On the 10-year chart for Light Crude we can see that it has already dropped to last ditch support in the $68 area. Once that fails - and it looks set to - it could easily plunge quickly to the mid to low $40's, or even lower. Rallies from oversold are likely to be stunted and short-lived, and therefore may be aggressively shorted, or exploited using inverse ETFs, like the leveraged PowerShares Crude Oil bear ETN, DTO, that we bought a few weeks back and which is soaring today.

We had been expecting extreme weakness in this sector in the last Oil Market update, although it took a little longer for the plunge to set in than we expected, and we are certainly seeing that now, and there is really "no light at the end of the tunnel" for the sector at this point.

US oil stocks, which are still at quite lofty levels despite today's plunge, look set to tank. They were wafted higher by the continued new highs in the broad stockmarket and now look very vulnerable, especially if the market as a whole rolls over.

Please note that this article may appear on some public websites.

Posted at 1.00 pm EST on 28th November 14.

Clive Maund
December 1st, 2014

Clive Maund is an English technical analyst, holding a diploma from the Society of Technical Analysts, Cambridge and lives in The Lake District, Chile.

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