Oil, unlike, say, gold, is a commodity of utility; not only do we need it to keep warm at night, but it’s not hyperbole or penmanship to say that it fuels most of the world’s economies. Nobody except OPEC and Hugo Chavez really thinks this is a good long-term plan for the human race, but it’s the real world.
It’s also, on the short term, a relatively predictable asset. A predictable amount will come out of the ground tomorrow, and the day after that. Get too far on that train of thought and you’ll have to delve into the peak-oil world, but it’s safe to say that we know where it’s coming from, we really know where it’s going and we know exactly how to get it from A to B. The infrastructure for moving petroleum around the world is more efficient and less prone to error than your Internet connection.
Most economists would tell you that such an efficient, highly liquid market would be somewhat immune to misinformation; after all, there are so many players, all of which know something; collectively, the market must know everything, right?
So why then do oil prices send headline writers looking for better explanations than “Oil futures plummeted on the meditations of a voodoo witch doctor in Des Moines?”
Because the dirty little secret of oil is that it trades more on information than it does on supply and demand. The driver of oil prices is not the barrels actually available on that proverbial loading dock in Cushing, Okla., but rather, on how likely it is that the same number of barrels can get there tomorrow. Because, as a commodity of utility, they have to be there tomorrow – almost no matter the price.
Let’s look at the replay, courtesy of WTRG Economics, an energy analytics group:
We all know that oil prices go up when there’s unrest in the Middle East, right? Everyone knows that. But when do they go up?
There are really only a few times in recent memory when we can say “AHA! Now THAT was a supply problem.”
Back in 1973 there was a little scuff-up in the Middle East you may remember as the “Yom Kippur War.” For a variety of reasons, world oil production – not just OPEC, but the actual amount of oil available to the market worldwide – dropped by 5 billion barrels a day. That was 7% of total production … and the price went up fourfold.
So it’s obvious right? Big to-do in the Middle East = big supply shortage = price rise. Well, kind of. The problem is that the prices always rise ahead of the actual supply shortage. And how far prices spike is open to a lot of speculation. So as is often the case, guessing early and right is the key to making the real money (in retrospect, could you have predicted the acrophobic price drop that followed the Gipper’s removal of U.S. price controls in 1981?).
That’s all complicated by the long lead times and the conservative nature of the oil industry. Even today, with oil prices sky high and people talking about $100/barrel oil, oil majors are planning their production patterns based on an average price of $40/barrel. It takes a long time for the majors to adjust to higher prices and build capacity, so the long-term supply/demand ratio adjusts only slowly.
Let’s turn our attention to the present. Recently, Iran has been making noise and insisting it will maintain its nuclear program. The result? Oil prices are high.
Well, on the one hand it makes sense. Perhaps we’re going to go to war with Iran, and Iranian oil production will collapse (again). But then again, perhaps everyone will hold hands and sing Kumbaya and Iran will actually have a nuclear power system in place in a few years and all that extra oil will flood the market. It’s easy to see which way the market’s betting, but is the market right?
As things get stirred up, future prices rise, because it becomes more important to know your car will start tomorrow, and a premium is paid for that guarantee; remember, oil is a utility commodity. So when it comes to war - say, the one we’re in right now - it’s the threat of change, the disruption of the status quo, that moves the market, more than the everyday reality of war.
And this is just one of dozens of factors to consider. Not only do you need to worry about the big picture, you need to worry about the little ones. Unrest, elections and strikes in Nigeria, Cyclones (think June 7’s Gonu near Iran)?
And then there’s the perennial problem of market expectation. If you stick to U.S.-dominated markets, like T-Bills, you only have to worry about the Fed, and you know exactly when you need to worry about what; the Fed’s meeting calendar is conveniently published. All of Chairman Bernanke’s appearances before Congress are carried on C-SPAN. But when the Saudi oil minister comments on an otherwise random day in February that the oil market is “healthy,” and this is considered rational CNN-level explanation for a price drop, clearly you’ve encountered a Federal-Reserve-of-a-different-color.
Was the market “pricing in” an OPEC cut? Well, according to the press it was. But if the price of oil had rallied that day, what would the headline have been? Is the headline driving the price or is the price driving the headline? Or how about this: the International Energy Agency released its June report stating that demand for world oil is up 2% from its previous forecast. And prices fell by the end of the day. Is the market anticipating OPEC finally giving in to pleas to increase production, even though it states it won’t?
Like so many things in commodities, unless you know something we don’t, you’d best pay really, really close attention to the facts if you’re betting on oil. Pipelines, production and politics. Technology, innovation, espionage and exploration. Either be a student of them all, or listen to experts like Ken Medlock, or make long-, long-term bets that stick with passive strategies and historical returns.
SeekingAlpha
by Hard Assets Investor
