Why cheap oil won't last

Right now there is oversupply of petroleum relative to demand. But it won't last.

1. Oil's oversupply problem, which has caused most of the trouble in the markets in recent years will end by 2017, and the market will return to balance.
2. Spare capacity will have shrunk substantially by then "to just 1% of global supply/demand." This HSBC argues, will make the market more susceptible to disruptions like those seen in Nigeria and Canada in 2016.
3. "Oil demand is still growing by ~1mbd every year, and no central scenarios that we recently assessed see oil demand peaking before 2040."
4. 81% of the production of liquid oil is already in decline.
5. HSBC sees between 3 and 4.5 million barrels per day of supply disappearing once peak oil production is reached. "In our view a sensible range for average decline rate on post-peak production is 5-7%, equivalent to around 3-4.5mbd of lost production every year."
6. Based on a simple calculation, HSBC estimates that by 2040, the world will need to find around 40 million barrels of oil per day to keep up with growing demand from emerging economies. That is equivalent to over 4 times the current crude oil output of Saudi Arabia.
7. "Small oilfields typically decline twice as fast as large fields, and the global supply mix relies increasingly on small fields: the typical new oilfield size has fallen from 500-1,000mb 40 years ago to only 75mb this decade." — This will exacerbate the problem of declining oil fields, and the lack of supply.
8. The amount of new oil discoveries being made is pretty small. HSBC notes that in 2015 the discovery rate for new wells was just 5%, a record low. The discoveries made are also fairly small in size.
9. There is potential for growth in US shale oil, but it currently represents less than 5% of global supply, meaning that it will not be able, single-handedly at least, to address the tumbling global supply HSBC expects.
10. "Step-change improvements in production and drilling efficiency in response to the downturn have masked underlying decline rates at many companies, but the degree to which they can continue to do so is becoming much more limited." Essentially HSBC argues that companies aren't improving their efficiency at a quick enough rate, meaning that supply declines will hit them even harder.

Yesterday, crude prices spiked sharply by several percentage points after,

U.S. commercial crude oil inventories declined by 14.5 million barrels during the week ending on September 2nd, according to the Energy Information Administration’s latest report.

The American Petroleum Institute (API) report on domestic inventories anticipated a 12 million barrel draw in crude supplies, against expert predictions that inventories would increase by 905,000 barrels.

ZeroHedge surmised that the massive decrease - the largest since January 1999 - occurred due to production shut-ins in the Gulf of Mexico caused by Tropical Storm Hermine. The temporary nature of weather events could mean the oil price spike caused by the draw will not be staying for long.

Which sounds about right since today crude prices dropped almost as sharply at market opening today. An oil futures ETF, USO (US Oil Fund, which I own zero shares thereof) tracks the price of crude at a 1:1 ratio; if oil rises by one percent, so does the share price of USO. USO closed Wednesday at $10.52 and closed Thursday, after the storage report, at $10.96, a 4.1 percent increase, which is a huge one-day price movement. Today, USO is down from yesterday's close by two percent, meaning it has given up almost half of Thursday's gain.

USO's price moves in direct ratio to spot-market oil prices. There are also funds that move in 2:1 and 3:1 ratio. And there are inverse funds that make the same ratios, only inversely to the price of oil. These are "short" funds because their prices rise when oil prices fall.

These oil ETFs have become a poplar investment vehicle for mom and pop investors because the potential for enormous returns is real. But remember the old saying about how to make a small fortune producing Broadway musicals: start with a large fortune.

Investment firms probably are making enormous sums on these ETFs since they have the auto-trading computer power to make multiple buys and sells in one day, heck in one hour or less. It is far from unusual for these funds to move up or down two percent in one day or even several times in one day. If a computer is programmed to sell every time there is a two percent profit the return will will be 22 percent in only five trades, and that can well be done in only one trading day. But individual investors should steer clear unless they have a huge willingness for very high volatility.