Energy Deflation: It’s here, it’s real and it’s gonna get worse!

by Joshua Enomoto, Founder of and Contributor

Last week in an OPEC conference held in Vienna, Austria, Nigeria’s oil minister, Diezani Alison-Madueke, stated that she was “gravely concerned” about the U.S. shale gas revolution potentially crippling her nation’s ability to profitably export crude oil, with the U.S. being a key partner for Nigeria. All pleasantries aside, she should be…while shale gas may not decimate prices in the short-term, the fat lady is warming up. In another hour or so, a G-sharp over high-C will be all that’s left from the shattering of glass and profits.

In the last several months, I have grown personally leery about the threat of deflation: after all, most people in the alternative investment community have dismissed such a possibility as “nonsense:” central banks across the globe are printing money. This means we’ll have inflation and that hard assets are the only way to protect ourselves…right?

Yes and no: certainly, if inflation is the primary catalyst, one only needs to stack as much gold bullion as he can get his hands on. But we cannot take inflation for granted and I fear that for many years, we may have collectively let down our guard. By assuming inflation as a constant, we then approached gold as the variable, as in, how much could we afford? But if the constant was wrong, the fundamental base of our equation would be flawed, and no matter how right our variable may appear to be, the answer itself would be erroneous.

Talking about deflation is not a popular subject and I have taken personal heat for this because I am a believer in hard assets and precious metals: the difference for me comes down to allocation. For investing, people must remain agnostic regardless of their personal preferences. Agnosticism keeps emotions in check and money in your wallet. Profits don’t care what generated them, and neither should you. And in the world of commodities, nothing lasts forever:

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Above is a chart that very few in the alternative media want to show you yet hiding from the facts is hardly a recipe for success. Regardless of the massive paradigm shift we have seen in the oil market over the last decade, where it appeared that we were eternally condemned to higher gas prices, the world has a strange way of throwing you a curveball. And while we may not enjoy the change-up, we really have only two choices: swing at it as if it were a dead-center fastball, or make the adjustment.

Three major indicators suggest that investors will need to choose the latter:
  • Resistance Since the futures price spike in July of 2008, subsequent peaks have met stiff resistance, and despite a record year in the commodities in 2011, the highest price achieved was $123/barrel, a full 8% lower than the all-time record. This is even more disconcerting when one considers the fact that the commodities bull run at that time was fueled by real street inflation from QE2. Both gold and silver went parabolic, but Brent crude did not follow. That may turn out to be the first of several warning signs that the great oil boom was coming to an end.
  • Head & Shoulders Pattern Often considered one of the more reliable indicators in technical analysis (derived from Elliot Wave Theory), the Head-and-Shoulders is a reversal pattern, in this case to the downside. It is characterized by three peaks, with the middle peak being the tallest. It suggests a tiredness of market participants to push the price higher, and by the third peak, the exuberance is all but exhausted. Head-and-Shoulders, if they appear, always do so after an uptrend, and upon its completion, usually marks a major trend reversal. For crude, the technicals are undeniably ugly, with the current price action failing to hold a 10-year support line. Earlier, in May of 2012, the price action did not sustain a 4-year rising trend line. Given these critical breakdowns, I am long crude no more!
  • No Demand China is slowing, street gas is falling, alternatives are moving: no matter which way you cut crude oil demand, the end conclusion is bearish. Very few commodities today face so much headwind: imagine if Newmont mining accidently stumbled a massive silver deposit that it shot the gold:silver ratio to 500:1? And the following day, J.P. Morgan publicly begins giving away Engelhard bricks in a desperate attempt to short the actual supply so they can begin manipulating again? Add on top of that the ugly technicals and you begin to appreciate the bigger picture. Crude oil is dying and there are no barrel stackers willing to buy at any price.
The implications reach far beyond the oil market: what has been the most cited detriment to a real recovery in the American economy? The high cost of imported oil and the opportunity cost of exported dollars! If shale gas is half of what we expect it to be, the cost of imported oil becomes virtually nothing while the cost of extraction is simply invested back into the American economy and more importantly, its labor force. Essentially, this is a win-win.

Who will be the losers? OPEC nations, particularly Nigeria, who depends on the United States as its biggest customer. At its peak, Nigeria exported 1.6 million barrels daily. Now, the average stand at about 543,000 barrels, a 66% decline. Considering that Nigeria is the largest oil producer in Africa, such a dramatic loss of revenue cannot be easy. Most of the drop-off was attributed to the type of oil that Nigeria produced, light-crude. However, with shale gas technology, American production of light crude surged, irrefutably confirming that this revolution is very much real and is already having a significant impact on the global markets. In time, those economies that have benefitted merely from possession of a natural resource will inevitably have their lights dimmed, if not altogether extinguished.

What does this mean for the individual investor? The future of oil futures is backwardation and therefore, any ETF’s tracking the long-side of the trade will likely be a money pit. And inverse-ETF’s might be a losing proposition as well, as backwardation may have the same effect on the short-trade as contango would have going long.

For oil companies, lesser known names such as South Africa’s SASOL appear technically suspect. Exotic names such as Russia’s Gazprom may die a slow and painful “paper” death. The companies that will survive the crude oil downturn will be those that are agile or those that don’t have to be (ie. Royal Dutch Shell, Exxon-Mobil).

Finally, this transition may mean that at some point, we may begin to have faith in our economy. And some day, we may be able to turn to our grandchildren and tell them how close we came to “the end” but somehow, someway…we avoided it.

Did we ever…!