How to Profit From OPEC's Misstep

Investors should be wary about reading headlines and overreacting without thoroughly vetting the claims made in bold print. 

One of the biggest headlines recently has been the agreement between OPEC members (and other oil-producing countries) to reduce production to help bring supply and demand into better balance.

OPEC has been hyping this accord for months now, and managed to push oil prices up 20% in the past month alone. 

Even though I don't believe OPEC members will adhere to their self-imposed cuts very long (if at all), several factors point to a correction in oil prices, which appears to already be getting underway.

On Wednesday, the Federal Reserve raised interest rates, which strengthened the U.S. dollar. Since oil is primarily traded in dollars, a strong greenback is bearish for the commodity. Additionally, a report showed OPEC output at record highs, with production increasing by 150,000 barrels a day in November. Both of these factors caused selling in oil this week, but I also want to look at the bigger reasons we can expect prices to correct further.

High Oil Prices are the Cure for High Prices 

For starters I see the OPEC deal as more of a marketing campaign than a real, fundamental shift in oil supply., 

On Nov. 30, OPEC promised cuts that would equate to a roughly 3% global drop in oil production. Despite being relatively insignificant, these promises had a profound effect on prices, which spiked to 18-month highs. 

While Saudi Arabia, the world's top oil producer, said this past weekend that it may reduce its output further than initially stated, the current agreement is to cap production at 10.06 million barrels per day. That's just 6% lower than its record high production rate of 10.7 million barrels a day, made back in July, and still more oil than the country has produced for most of the past four years. 

What's more, North American producers have made no agreements to cut production. In fact, many have already begun to ramp up production and delivery of crude oil in response to the higher prices triggered by OPEC. 

Crude prices have doubled from their 2016 lows and this makes it a great time to produce a ton of petroleum and/or sell oil futures to lock in these prices, both of which have a bearish effect on future oil prices. 

And while the United States is the biggest global oil consumer, we're no longer helplessly subject to OPEC's pricing controls. 

Improved technology has helped North American drillers reduce their costs of getting oil out of the ground and to market. As a result, oil prices in the $30-$50 range are now very profitable for a great number of North American drillers when they weren't just five to 10 years ago. 

New mega discoveries have also changed the game. For example, a recent discovery in Texas is the largest continuous deposit ever found in the States. At 20 billion barrels, it solidifies the fact that our oil reserves have surpassed those of Saudi Arabia and Russia. 

And now American producers are starting to ramp up production on those reserves. Last week, the number of total working U.S. oil rigs jumped by 27. This was the largest weekly increase since April 2014, when oil prices were double what they are today. 

Canadian production is also coming online fast, with our neighbors to the north adding 30 rigs last week. This put the rig count at 230 -- 56 more than were operating at this time last year. 

Interestingly, the U.S. rig count is still down by 85 compared to last year and nowhere near full capacity. Just two years ago, there were nearly 2,000 rigs operating in the United States alone, compared with 624 currently. This leaves a lot of room for expansion. 

The countries that are party to the production cuts need oil money to keep their economies and governments afloat. With American production already increasing, OPEC members must be careful not to shoot themselves in the foot and hike prices to a point that puts too many North American wells back online, especially with President-elect Trump's "Drill, baby, drill!" attitude. 

The higher oil prices go, the more rigs that will come online, which should easily soak up OPEC's small production cuts and drive prices lower. 

OPEC Cuts Bring More Export Opportunities for US 

OPEC's little game is also backfiring with regard to exports. 

Last year, the U.S. government lifted a 40-year ban on petroleum exports, opening a window of opportunity to send our oil overseas. Combined with OPEC's production cuts and the subsequent jump in oil prices, this make it viable for us to export good ol' Texas tea, especially to a thirsty Asia. In fact, BP (NYSE: BP) is already piloting a program to do just that. 

Industry experts also believe OPEC's reduced exports will trigger a drop in tanker shipping rates, making it easier and cheaper for North American oil to get to destinations around the world. 

The way I see it, we're facing two possible scenarios. The first is that OPEC is overstating its commitment to lowering production, which will prevent prices from moving meaningfully higher. Second, even if OPEC does curtail its output to send prices higher, it only invites production from other countries, like the United States, which are finding it easier to export that oil to the rest of the world. 

Either way, I don't see oil prices going any higher than the $40-$50 range, where they have been for most of the past year, especially until global economies shift back into high gear. 

Finally, seasonality is on the bears' side as well, with the November-to-March period being historically weak for oil prices.

For those who aren't interested in trading commodity futures, the United States Oil ETF (NYSE: USO) is a great proxy. It trades just like a stock and uses futures to mimic moves in crude.

My initial downside target for USO is a drop to $11.05 -- a key support level that coincides with pivot points going back to August.

You could short shares to take advantage of this potential downside. Shorting 100 shares of USO on a 50% margin would cost about $568. However, with the initial target only about 3% below the current price, it may not be worth the risk. USO could certainly break lower at $11.05, but when shorting a stock or ETF, you're losses are theoretically unlimited.

As an alternative, I recently told traders about a way they could turn that drop in USO into a 25.8% return while risking as little as $155. I don't have the space to go into it here, but if you're interested in learning how it's done, follow this link.

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