Without a doubt, crude oil has been the commodity with the most buzz surrounding it over the last three years. Every investor and analyst (especially those geniuses on CNBC) has an explanation for every single move, but more often than not they are either misinformed or lying.
The importance of crude oil to our world financial markets is very important; it affects everything from companies’ transportation costs to consumer behavior and spending habits. Being able to predict the future price or price movements would be an invaluable skill, but the question is how would an investor even go about this? I believe the basis of this unattainable skill is influenced by a wide number of factors.
After I realized that this article was quickly turning into a book and then into an encyclopedia, I thought the title may be somewhat misleading. After some more thought, I decided to break up this post into a Five Part series. On top of that, the concepts I have presented are not very in depth, but they take time and a lot of writing to put into context.
Without a general understanding of these concepts that I am about to delve into, you will not be able to fully grasp the scope of the larger concept.
Crude oil has one of the most complex and variable pricing mechanisms in the commodities market. It is even more complex than almost every other liquid asset class. Crude oil pricing is affected by a host of different factors, and it can be extremely difficult to determine which factors have the greatest impact on the actual spot price at any given point in time.
As you have certainly seen in recent months, the crude oil markets have been extremely volatile and it is possible to make or lose a large sum of money very quickly. Many investors believe that the crude oil markets are susceptible to heavy manipulation, but when attempting to present evidence, their thesis generally comes up short. A good example of this would be that these “speculators” have been net short crude oil from early March 2008.
During this time period, crude actually appreciated from the $110-$120 range all the way up to $147 even though there were heavy bets against the commodity. While I don’t believe that manipulation drives oil markets, I am not saying that manipulation doesn’t take place. Instead I would like to focus on other factors that have been affecting crude recently:
Fundamentals of Supply and Demand
OPEC
Russia
Shortages, Stockpiles, and Decline Rates
Discoveries
Currency
Refiners and the Crack Spread
Geo-political Tensions
Weather Threats
Fear and Uncertainty
Other Risks
Hopefully I can shed some light on these factors as I will be the first person to tell you that I am not a sooth-sayer. I can tell you for certain that anyone who has a prediction for the price of crude in the short term shouldn’t be taken seriously because of their arrogance and lack of intelligence on how crude oil has historically traded in terms of volatility.
While I believe no one can predict short term movements, I do believe that with a strong understanding of macro economic factors as well as supply and demand it is possible to formulate a reliable general prediction for where crude oil will be trading far out into the future, somewhere in the range of 5 years and beyond. General stock market news in general can also have an effect, but I would rather explore some of the deeper points.
Fundamentals of Supply and Demand
The most basic metric for crude pricing is the simple fundamentals behind world wide supply and demand. Obviously these two factors are not exactly known down to the barrel, but it is widely accepted that crude oil supply is around 85 million barrels per day (Mbpd) and demand is around 86.5 Mbpd.
However, during the current crunch many experts believe that worldwide demand has dropped due to the severe economic slowdown that is looming upon us and about to occur starting next quarter. With a basic understanding of economics you can understand that this discrepancy must be filled through a market clearing price. This market clearing price occurs whenever approximately 1.65 Mbpd of demand is “priced out of the market.”
This single value is the basis for crude oil pricing but by no means is the only factor. Supply and demand may be the most important factor because all of the other factors can have a direct impact on supply and demand on a daily, monthly, or yearly basis. Supply and demand is the metric that investors always will go by whenever they are interested in long term horizons, basically any time period from 5 years to 30+ years.
OPEC
The Organization of Petroleum Exporting Countries (commonly referred to as OPEC) is the world’s largest cartel. It consists of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. OPEC has control of roughly two-thirds of the world’s oil reserves and 35% of the world’s crude production (these numbers do not include tar sands and other unconventional forms of hydrocarbons). OPEC collectively places production quotas on its nations which in turn affect world wide supply. Often times countries within OPEC ignore quotas to promote their own economic interests but the net change from the total quota generally has been minimal.
Generally OPEC aims to keep oil prices increasing steadily at a rate slightly greater than inflation but there has been evidence and accusations of manipulating the market for other purposes, particularly in terms of the United States Presidential elections.
Many industry experts believe that the Saudis (OPEC’s largest member) purposely hold reserves until around the time of the election, and either add or take reserves from the market to help push for the election of the candidate that is most likely to continue America’s reliance on foreign oil. Obviously because transparency within OPEC is microscopic at best, this is impossible to prove but there has been a history of oil price spikes and drops around the half year before the election.
Russia
Depending on which day you look at the statistics, Russia is either the largest or the second largest producer of crude oil in the world. As you can imagine this allows Russia to have a great amount of pull in the world oil markets. While I do not believe Russia is currently trying to take crude oil off of the market to cause a price spike, I do believe they are supplying less oil to the rest of the market because they are consuming more to further their economic development.
Their export numbers were down last quarter and I wouldn’t be surprised to see them hold steady or drop again when the next quarter’s numbers are reported. Russia is currently listed as having the eighth largest crude oil reserve in the world, but I highly suspect that this number is inaccurate. Because of the political and economic instability that has taken place in the region over the last 50 years, proper surveying has not been completed and it is highly likely that within the next five to ten years there will be substantial oil finds in Russia. This is especially likely in the northern portions and offshore where very little work has been completed.
Another interesting factor when thinking about the future of Russia’s involvement with the world crude oil markets will be how it uses its political power. There have been rumors that Russia is interested in joining OPEC. This would instantly transform OPEC from a semi-legitimate cartel into the premiere market maker.
While I still think this is unlikely, this type of move would be a way for Russia to take a backwards strike at the United States. Even if Russia joins OPEC it doesn’t necessarily mean that their power will increase because many of the countries within OPEC act as rogue members and do not listen to the production quotas set by the council. When a country can further it’s own economic interest, OPEC and its feelings take a back seat.
Russia has also been slowly encroaching into other oil rich areas that tend to be part of the former U.S.S.R. Georgia has sizable crude oil reserves as well as a key pipeline that supplies Europe with a lot of energy. If Russia were to take over Georgia, either literally or through political pressure, they would have an even larger energy stranglehold on Western and Central Europe, especially in terms of natural gas supply.
Do not be surprised if you see LUKOIL, Gazprom, or Gazprom Neft expanding their territory further outside Russia’s borders with the help of Vladimir Putin. Putin is an extremely smart and thoughtful leader who understands the need for natural resources going into the future and he has determined that those who control natural resources will control the world in the future. He is also an astute student of “cold-war” type politics and has proven this through his neglect of anything the West tries to offer.
Shortages, Stockpiles, and Decline Rates
Often one of the most important short term pricing factors in regards to crude oil are shortages and stockpiles. These dynamics work in ways that are mysterious to most investors and misunderstood by many others. It is easy to understand that reports or rumors of any shortages will cause the market to price in future shifts in supply, that in-turn, will tighten the supply.
This conceptual logic also applies to decline rates. Decline rates are the rates at which oil or gas fields and wells “shrink” in terms of production. This number is generally quoted in a year-over-year metric and is a great measure when projecting and modeling future production. Decline rates are generally only issued after a well has surpassed its peak production phase, under most circumstances 2-6 years after the well has started producing oil.
Obviously different types of wells from different geographical locations have different average decline rates. Because there is a wealth of historical information available on decline rates, the market has priced in expected future supply of oil. The shifts in the price of crude oil occurs when the decline rates are either greater or smaller than expected. Obviously smaller than expected decline rates will cause future supply predictions to increase, and greater than expected decline rates will cause future supply predictions to decrease.
This same scenario is reflected when investors are looking at crude oil stockpiles. The Energy Information Agency (EIA) produces a report that is released at 10:35 AM EST on Wednesday of every week that collects data on the amount of crude that is currently in storage. Every week analysts predict numbers for barrels of crude oil, gasoline, heating distillate, and the refinery utilization rates. If these reports come out and are either above or below analyst expectations it is likely that the price of crude oil will fluctuate. (As a side note, the EIA also produces a natural gas inventory report that is released on the Thursday of every week at 10:35 AM EST.)
Discoveries
Just as shortages have an effect on the pricing of crude oil, so do new discoveries. New discoveries generally bring down the price of crude oil because investors will predict new supply coming online in future years after the new resources are tapped into. A great example of this are the new discovery announcements that have recently come out of Brazil. Petroleo Brazileiro (PBR: 30.58 +4.21 +15.97%), Brazil’s largest oil company which is partially state-owned, announced the discovery of the Tupi field in 2006 and the Jupiter field in 2008.
These are two pre-salt layer petroleum fields that contain a vast number of reserves. Current estimates are that the Jupiter field contains 5-8 billion barrels of oil and that the Tupi field contains 7-30 billion barrels of oil. When these announcements were made, the price of oil came down because of the expectation for increased supply not only from these two fields, but also from the speculation that other reserves may be found in the pre-salt layer crust level of the Earth.
Conventional discoveries have been slowing down in terms of number and magnitude as the world’s population uses all of the easily accessible oil. It is very likely that in the future discovery announcements will come in the form of unconventional sources of oil, such as oil sands, rock basins, and other sources deep under the Earth’s surface.
An excellent way to keep up with announcements of discoveries is to reference the Wikipedia Oil Megaprojects page. This website lists all of the new megaprojects, their location, their production, and their time frame. From all of my research I believe it is the most comprehensive and user friendly compilation of discoveries and megaprojects information on the internet. The link for the website can be found here.
Currency
Probably the most under appreciated determinant of crude oil prices is currency. Many investors forget that the foreign exchange markets sometimes are the entire reason for a move up or down in oil. Crude oil around the world on almost all exchanges is denominated in U.S. Dollars and a change in the base currency of an asset will cause the assets value to fluctuate in terms of other currencies.
As you can imagine the recent volatility in the foreign exchange market, especially in regards to the U.S. Dollar, have only compounded the complexity and volatility within the crude oil markets. Obviously there is no way to measure what effect a change in the U.S. Dollar against any basket of currencies has on crude oil, because there is no way to isolate currency as the only variable within crude oil pricing.
Many experts currently believe that roughly a 1% gain or loss for the U.S. Dollar Index will represent approximately a $3.00 gain or loss in the price of crude oil respectively. During this current liquidity and credit crisis it is not uncommon to see the U.S. Dollar Index move up or down 2% in one day, which would help to explain why there have been giant record setting moves up and down in crude over the last six months. This theory also happens to perfectly coincide with the rise of oil to $147 when the Dollar was appreciating and the subsequent fall back down as the dollar appreciated heavily against the Euro and British Pound over the last month or two.
During volatile times, especially currently during the massive market panic, crude oil has not traded in lock step with the United States Dollar. This is a special circumstance where multiple negatively correlated assets can trade in a correlated manner for a small period of time. In this example it would be the United States Dollar and crude oil depreciating simultaneously. The events of the last two weeks in respect to the currency and crude oil markets are aberrations and are extremely unlikely to occur again unless another similar situation arises in the distant future.
Refiners and the Crack Spread
The general misconception that the demand of crude oil is that it comes directly from “whoever pulls it out of the ground to their cars.” Unfortunately this is flawed thinking as they neglect many steps in between the first and last steps. The refiners are the ones who actually control the demand of crude oil, not the consumers. Their demand for the most part is dictated by the “crack spread.”
The crack spread is the term that refers to the profit margin of refiners. It comes from the process of “cracking” a barrel of crude oil, or refining a barrel of crude oil into a useful output. In most cases, this output is either gasoline or heating distillate, although there are many different outputs. The most common crack spread is the 3:2:1 crack spread, or 3 barrels of crude is refined into 2 barrels of gasoline and 1 barrel of heating distillate. Again, there is more than just one crack spread variation.
Crack spreads are always quoted using spot market pricing for the equations. Because of this, the crack spread is not always a 100% accurate indicator of refining activity. Unless a refiner is completely unhedged, their input and output prices are not going to be the same as the spot market prices. That being said, the crack spread is a pretty decent indicator of crude oil demand. The larger the profit margin is from the crack spread, the more demand there will be, and therefore, refining activity will pick up. The refiners are worried about making a decent profit margin due to the fact that they are also being squeezed by input prices (in the exact same manner that consumers are squeezed by input prices). Providing the general public with cheap gasoline is not the refiner’s chief concern.
Geo-political Tensions
There have been books of multiple volumes written on this topic, but I’ll try to keep it short and confined to only recent news. In general, geo-political tensions will cause the price of oil to go up because investors will attempt to price in the risk of potential supply coming offline in the future. This supply could be disrupted for a number of reasons, taxes, tariffs, elections, economic sanctions, embargoes, blockades, and in some cases war. A good example of this was the time period before the United States started their War on Terrorism.
Oil appreciated on the news because investors suspected some sort of slow down in productions from the Middle East. It turns out they were right as Iraqi crude production was cut down by about 45% from its peak before the war. Investors also priced in extra supply coming on in the future once the oil majors began to announce new projects that they had signed with the new Iraqi government (Iraqi production by most estimates is now above the pre-war high).
Another appropriate example is when President Mahmoud Ahmenijhad of Iran began to threaten other countries and released the photo-shopped photos of the Iranian cruise missile tests. The price of crude oil futures appreciated on the belief that there would be supply shortages from a conflict in the Middle East in the near future. Geo-political tensions have historically been what has caused some of the largest swings in crude prices and I would expect this to continue into the foreseeable future.
Weather Threats
As we have seen recently, weather threats have a severe impact on commodities (and the energy sector as a whole). Hurricanes Gustav and Ike of 2008 are examples of counter-intuitive price movements in oil because of other overriding factors that were simultaneously taking place, so I would rather focus on Hurricane Katrina of 2005.
During Hurricane Katrina oil prices spiked for a number of reasons. Firstly, production both onshore and offshore was forced off-line cutting the supply. Because supply was cut domestically, there was also an added need for imported oil which meant that demand from the United States was driving the price even higher than normal.
On top of that, crude prices were driven up because a great majority of the domestic transportation infrastructure (pipelines) in the southern United States was also offline. This event caused a panic and crude prices soared, which in turn caused many other commodity prices to soar. Many investors will attempt to price in the effects of upcoming weather events into the price of crude oil. This was seen with the run up in price before hurricanes that took place after Hurricane Katrina as investors learned their lesson.
Fear and Uncertainty
Fear and uncertainty is the worst enemy of a financial market, and if you turn on the television it is easy to see why this is the case and how it can affect the world financial markets. Within the crude oil markets, fear and panic can cause a severe move in either direction.
During this current credit crunch and liquidity crisis we have seen crude oil drop from its peak of $147 all the way down below $80 a barrel. This drop was not based on supply and demand metrics, but on investors fearfully pulling out their remaining capital from all segments of the market. Margin calls have become even more prevalent, especially when asset prices are decreasing.
This has the exact opposite effect of a short squeeze. You can read more about the affects of a short squeeze on oil in another article I have written, [5] http://www.bullishbankers.com/why-was-crude-up-huge-on-monday/. Fear will cause crude oil to be priced irrationally and it is impossible to quantify its effects on the price even though it is blatantly apparent that it exists within the market.
Other Risks
Obviously there are many factors that have a bearing on the price of crude oil; I would need to write for another year or two to name them all. The factors I have laid out are the most commonly talked about factors, but by no means necessarily the most important factors. One time events generally have an effect on the markets, as well as events that surface every so often. A good example of this is the potential problems and conflicts involving the Strait of Hormuz.
This strategically positioned strait is located between Iran and Oman and is probably the single most important geographical location in the world in regards to crude oil pricing. Because of the vast amount of crude oil production coming from the Middle East, it is estimated that roughly ~40% of the world’s crude oil travels through this strait on a daily basis. If anything were to happen to the strait, the crude oil markets would be in complete meltdown. The realization of this threat has never been real, until recent threats from Iran’s President Mahmoud Ahmenijhad mentioning sinking Iran’s own oil tankers to block the strait in order to inflict financial pain on nations who rely heavily on crude oil.
Luckily the United States has a naval fleet stationed full-time near the strait, but that does not necessarily mean that an attack could be averted. Certain special situations such as this hypothetical scenario will generally have an upward effect on crude oil.
Final Thoughts
Obviously the information presented above and in this set of articles is an extremely large collection of information that is only a relatively small piece of the entire puzzle. The market in many cases is fairly efficient and there are other factors priced into crude oil that no one can even begin to understand. As I have stated above, there is no set equation to determine what a barrel of crude oil is worth but I think it is very apparent that if there is an overriding factor, it is the all encompassing supply and demand equation. Even this seemingly simple concept is almost impossible to map when it comes to crude oil, and all of the other variables make the real equation unknown.
There are many great sources for information on crude oil, especially in terms of history, pricing, and how macro economics affect crude oil. If you are interested in learning more about crude oil and its rise I would highly recommend reading the book The Prize: The Epic Quest for Oil, Money, and Power by Daniel Yergin. This Pulitzer Prize winning book is the most accurate and in depth description of the history of crude oil as well as the macro economic ideas that are important to the past, present, and future of the commodity. The book is over 900 pages long but it is one of the best books I have ever read and for anyone invested or planning on investing heavily in energy stocks it is a must read.
I believe that there are three important things to remember: firstly, over the short term and sometimes intermediate term, the fair value for a barrel of crude oil is what the market says it is and nothing else. Secondly, the market does not always digest information in the fashion that seems the most logical. Often times new information will surface that would seem to be bullish or bearish for crude oil and the price will react in the exact opposite manner.
This may occur because there are other factors at play simultaneously: other investors do not come to the same conclusions from the same information, or for other reasons that are seemingly illogical. Finally, as much as you or I may think that we know about crude oil and its market, there is an even larger amount of information that we do not know.
The importance of crude oil to our world financial markets is very important; it affects everything from companies’ transportation costs to consumer behavior and spending habits. Being able to predict the future price or price movements would be an invaluable skill, but the question is how would an investor even go about this? I believe the basis of this unattainable skill is influenced by a wide number of factors.
After I realized that this article was quickly turning into a book and then into an encyclopedia, I thought the title may be somewhat misleading. After some more thought, I decided to break up this post into a Five Part series. On top of that, the concepts I have presented are not very in depth, but they take time and a lot of writing to put into context.
Without a general understanding of these concepts that I am about to delve into, you will not be able to fully grasp the scope of the larger concept.
Crude oil has one of the most complex and variable pricing mechanisms in the commodities market. It is even more complex than almost every other liquid asset class. Crude oil pricing is affected by a host of different factors, and it can be extremely difficult to determine which factors have the greatest impact on the actual spot price at any given point in time.
As you have certainly seen in recent months, the crude oil markets have been extremely volatile and it is possible to make or lose a large sum of money very quickly. Many investors believe that the crude oil markets are susceptible to heavy manipulation, but when attempting to present evidence, their thesis generally comes up short. A good example of this would be that these “speculators” have been net short crude oil from early March 2008.
During this time period, crude actually appreciated from the $110-$120 range all the way up to $147 even though there were heavy bets against the commodity. While I don’t believe that manipulation drives oil markets, I am not saying that manipulation doesn’t take place. Instead I would like to focus on other factors that have been affecting crude recently:
Fundamentals of Supply and Demand
OPEC
Russia
Shortages, Stockpiles, and Decline Rates
Discoveries
Currency
Refiners and the Crack Spread
Geo-political Tensions
Weather Threats
Fear and Uncertainty
Other Risks
Hopefully I can shed some light on these factors as I will be the first person to tell you that I am not a sooth-sayer. I can tell you for certain that anyone who has a prediction for the price of crude in the short term shouldn’t be taken seriously because of their arrogance and lack of intelligence on how crude oil has historically traded in terms of volatility.
While I believe no one can predict short term movements, I do believe that with a strong understanding of macro economic factors as well as supply and demand it is possible to formulate a reliable general prediction for where crude oil will be trading far out into the future, somewhere in the range of 5 years and beyond. General stock market news in general can also have an effect, but I would rather explore some of the deeper points.
Fundamentals of Supply and Demand
The most basic metric for crude pricing is the simple fundamentals behind world wide supply and demand. Obviously these two factors are not exactly known down to the barrel, but it is widely accepted that crude oil supply is around 85 million barrels per day (Mbpd) and demand is around 86.5 Mbpd.
However, during the current crunch many experts believe that worldwide demand has dropped due to the severe economic slowdown that is looming upon us and about to occur starting next quarter. With a basic understanding of economics you can understand that this discrepancy must be filled through a market clearing price. This market clearing price occurs whenever approximately 1.65 Mbpd of demand is “priced out of the market.”
This single value is the basis for crude oil pricing but by no means is the only factor. Supply and demand may be the most important factor because all of the other factors can have a direct impact on supply and demand on a daily, monthly, or yearly basis. Supply and demand is the metric that investors always will go by whenever they are interested in long term horizons, basically any time period from 5 years to 30+ years.
OPEC
The Organization of Petroleum Exporting Countries (commonly referred to as OPEC) is the world’s largest cartel. It consists of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. OPEC has control of roughly two-thirds of the world’s oil reserves and 35% of the world’s crude production (these numbers do not include tar sands and other unconventional forms of hydrocarbons). OPEC collectively places production quotas on its nations which in turn affect world wide supply. Often times countries within OPEC ignore quotas to promote their own economic interests but the net change from the total quota generally has been minimal.
Generally OPEC aims to keep oil prices increasing steadily at a rate slightly greater than inflation but there has been evidence and accusations of manipulating the market for other purposes, particularly in terms of the United States Presidential elections.
Many industry experts believe that the Saudis (OPEC’s largest member) purposely hold reserves until around the time of the election, and either add or take reserves from the market to help push for the election of the candidate that is most likely to continue America’s reliance on foreign oil. Obviously because transparency within OPEC is microscopic at best, this is impossible to prove but there has been a history of oil price spikes and drops around the half year before the election.
Russia
Depending on which day you look at the statistics, Russia is either the largest or the second largest producer of crude oil in the world. As you can imagine this allows Russia to have a great amount of pull in the world oil markets. While I do not believe Russia is currently trying to take crude oil off of the market to cause a price spike, I do believe they are supplying less oil to the rest of the market because they are consuming more to further their economic development.
Their export numbers were down last quarter and I wouldn’t be surprised to see them hold steady or drop again when the next quarter’s numbers are reported. Russia is currently listed as having the eighth largest crude oil reserve in the world, but I highly suspect that this number is inaccurate. Because of the political and economic instability that has taken place in the region over the last 50 years, proper surveying has not been completed and it is highly likely that within the next five to ten years there will be substantial oil finds in Russia. This is especially likely in the northern portions and offshore where very little work has been completed.
Another interesting factor when thinking about the future of Russia’s involvement with the world crude oil markets will be how it uses its political power. There have been rumors that Russia is interested in joining OPEC. This would instantly transform OPEC from a semi-legitimate cartel into the premiere market maker.
While I still think this is unlikely, this type of move would be a way for Russia to take a backwards strike at the United States. Even if Russia joins OPEC it doesn’t necessarily mean that their power will increase because many of the countries within OPEC act as rogue members and do not listen to the production quotas set by the council. When a country can further it’s own economic interest, OPEC and its feelings take a back seat.
Russia has also been slowly encroaching into other oil rich areas that tend to be part of the former U.S.S.R. Georgia has sizable crude oil reserves as well as a key pipeline that supplies Europe with a lot of energy. If Russia were to take over Georgia, either literally or through political pressure, they would have an even larger energy stranglehold on Western and Central Europe, especially in terms of natural gas supply.
Do not be surprised if you see LUKOIL, Gazprom, or Gazprom Neft expanding their territory further outside Russia’s borders with the help of Vladimir Putin. Putin is an extremely smart and thoughtful leader who understands the need for natural resources going into the future and he has determined that those who control natural resources will control the world in the future. He is also an astute student of “cold-war” type politics and has proven this through his neglect of anything the West tries to offer.
Shortages, Stockpiles, and Decline Rates
Often one of the most important short term pricing factors in regards to crude oil are shortages and stockpiles. These dynamics work in ways that are mysterious to most investors and misunderstood by many others. It is easy to understand that reports or rumors of any shortages will cause the market to price in future shifts in supply, that in-turn, will tighten the supply.
This conceptual logic also applies to decline rates. Decline rates are the rates at which oil or gas fields and wells “shrink” in terms of production. This number is generally quoted in a year-over-year metric and is a great measure when projecting and modeling future production. Decline rates are generally only issued after a well has surpassed its peak production phase, under most circumstances 2-6 years after the well has started producing oil.
Obviously different types of wells from different geographical locations have different average decline rates. Because there is a wealth of historical information available on decline rates, the market has priced in expected future supply of oil. The shifts in the price of crude oil occurs when the decline rates are either greater or smaller than expected. Obviously smaller than expected decline rates will cause future supply predictions to increase, and greater than expected decline rates will cause future supply predictions to decrease.
This same scenario is reflected when investors are looking at crude oil stockpiles. The Energy Information Agency (EIA) produces a report that is released at 10:35 AM EST on Wednesday of every week that collects data on the amount of crude that is currently in storage. Every week analysts predict numbers for barrels of crude oil, gasoline, heating distillate, and the refinery utilization rates. If these reports come out and are either above or below analyst expectations it is likely that the price of crude oil will fluctuate. (As a side note, the EIA also produces a natural gas inventory report that is released on the Thursday of every week at 10:35 AM EST.)
Discoveries
Just as shortages have an effect on the pricing of crude oil, so do new discoveries. New discoveries generally bring down the price of crude oil because investors will predict new supply coming online in future years after the new resources are tapped into. A great example of this are the new discovery announcements that have recently come out of Brazil. Petroleo Brazileiro (PBR: 30.58 +4.21 +15.97%), Brazil’s largest oil company which is partially state-owned, announced the discovery of the Tupi field in 2006 and the Jupiter field in 2008.
These are two pre-salt layer petroleum fields that contain a vast number of reserves. Current estimates are that the Jupiter field contains 5-8 billion barrels of oil and that the Tupi field contains 7-30 billion barrels of oil. When these announcements were made, the price of oil came down because of the expectation for increased supply not only from these two fields, but also from the speculation that other reserves may be found in the pre-salt layer crust level of the Earth.
Conventional discoveries have been slowing down in terms of number and magnitude as the world’s population uses all of the easily accessible oil. It is very likely that in the future discovery announcements will come in the form of unconventional sources of oil, such as oil sands, rock basins, and other sources deep under the Earth’s surface.
An excellent way to keep up with announcements of discoveries is to reference the Wikipedia Oil Megaprojects page. This website lists all of the new megaprojects, their location, their production, and their time frame. From all of my research I believe it is the most comprehensive and user friendly compilation of discoveries and megaprojects information on the internet. The link for the website can be found here.
Currency
Probably the most under appreciated determinant of crude oil prices is currency. Many investors forget that the foreign exchange markets sometimes are the entire reason for a move up or down in oil. Crude oil around the world on almost all exchanges is denominated in U.S. Dollars and a change in the base currency of an asset will cause the assets value to fluctuate in terms of other currencies.
As you can imagine the recent volatility in the foreign exchange market, especially in regards to the U.S. Dollar, have only compounded the complexity and volatility within the crude oil markets. Obviously there is no way to measure what effect a change in the U.S. Dollar against any basket of currencies has on crude oil, because there is no way to isolate currency as the only variable within crude oil pricing.
Many experts currently believe that roughly a 1% gain or loss for the U.S. Dollar Index will represent approximately a $3.00 gain or loss in the price of crude oil respectively. During this current liquidity and credit crisis it is not uncommon to see the U.S. Dollar Index move up or down 2% in one day, which would help to explain why there have been giant record setting moves up and down in crude over the last six months. This theory also happens to perfectly coincide with the rise of oil to $147 when the Dollar was appreciating and the subsequent fall back down as the dollar appreciated heavily against the Euro and British Pound over the last month or two.
During volatile times, especially currently during the massive market panic, crude oil has not traded in lock step with the United States Dollar. This is a special circumstance where multiple negatively correlated assets can trade in a correlated manner for a small period of time. In this example it would be the United States Dollar and crude oil depreciating simultaneously. The events of the last two weeks in respect to the currency and crude oil markets are aberrations and are extremely unlikely to occur again unless another similar situation arises in the distant future.
Refiners and the Crack Spread
The general misconception that the demand of crude oil is that it comes directly from “whoever pulls it out of the ground to their cars.” Unfortunately this is flawed thinking as they neglect many steps in between the first and last steps. The refiners are the ones who actually control the demand of crude oil, not the consumers. Their demand for the most part is dictated by the “crack spread.”
The crack spread is the term that refers to the profit margin of refiners. It comes from the process of “cracking” a barrel of crude oil, or refining a barrel of crude oil into a useful output. In most cases, this output is either gasoline or heating distillate, although there are many different outputs. The most common crack spread is the 3:2:1 crack spread, or 3 barrels of crude is refined into 2 barrels of gasoline and 1 barrel of heating distillate. Again, there is more than just one crack spread variation.
Crack spreads are always quoted using spot market pricing for the equations. Because of this, the crack spread is not always a 100% accurate indicator of refining activity. Unless a refiner is completely unhedged, their input and output prices are not going to be the same as the spot market prices. That being said, the crack spread is a pretty decent indicator of crude oil demand. The larger the profit margin is from the crack spread, the more demand there will be, and therefore, refining activity will pick up. The refiners are worried about making a decent profit margin due to the fact that they are also being squeezed by input prices (in the exact same manner that consumers are squeezed by input prices). Providing the general public with cheap gasoline is not the refiner’s chief concern.
Geo-political Tensions
There have been books of multiple volumes written on this topic, but I’ll try to keep it short and confined to only recent news. In general, geo-political tensions will cause the price of oil to go up because investors will attempt to price in the risk of potential supply coming offline in the future. This supply could be disrupted for a number of reasons, taxes, tariffs, elections, economic sanctions, embargoes, blockades, and in some cases war. A good example of this was the time period before the United States started their War on Terrorism.
Oil appreciated on the news because investors suspected some sort of slow down in productions from the Middle East. It turns out they were right as Iraqi crude production was cut down by about 45% from its peak before the war. Investors also priced in extra supply coming on in the future once the oil majors began to announce new projects that they had signed with the new Iraqi government (Iraqi production by most estimates is now above the pre-war high).
Another appropriate example is when President Mahmoud Ahmenijhad of Iran began to threaten other countries and released the photo-shopped photos of the Iranian cruise missile tests. The price of crude oil futures appreciated on the belief that there would be supply shortages from a conflict in the Middle East in the near future. Geo-political tensions have historically been what has caused some of the largest swings in crude prices and I would expect this to continue into the foreseeable future.
Weather Threats
As we have seen recently, weather threats have a severe impact on commodities (and the energy sector as a whole). Hurricanes Gustav and Ike of 2008 are examples of counter-intuitive price movements in oil because of other overriding factors that were simultaneously taking place, so I would rather focus on Hurricane Katrina of 2005.
During Hurricane Katrina oil prices spiked for a number of reasons. Firstly, production both onshore and offshore was forced off-line cutting the supply. Because supply was cut domestically, there was also an added need for imported oil which meant that demand from the United States was driving the price even higher than normal.
On top of that, crude prices were driven up because a great majority of the domestic transportation infrastructure (pipelines) in the southern United States was also offline. This event caused a panic and crude prices soared, which in turn caused many other commodity prices to soar. Many investors will attempt to price in the effects of upcoming weather events into the price of crude oil. This was seen with the run up in price before hurricanes that took place after Hurricane Katrina as investors learned their lesson.
Fear and Uncertainty
Fear and uncertainty is the worst enemy of a financial market, and if you turn on the television it is easy to see why this is the case and how it can affect the world financial markets. Within the crude oil markets, fear and panic can cause a severe move in either direction.
During this current credit crunch and liquidity crisis we have seen crude oil drop from its peak of $147 all the way down below $80 a barrel. This drop was not based on supply and demand metrics, but on investors fearfully pulling out their remaining capital from all segments of the market. Margin calls have become even more prevalent, especially when asset prices are decreasing.
This has the exact opposite effect of a short squeeze. You can read more about the affects of a short squeeze on oil in another article I have written, [5] http://www.bullishbankers.com/why-was-crude-up-huge-on-monday/. Fear will cause crude oil to be priced irrationally and it is impossible to quantify its effects on the price even though it is blatantly apparent that it exists within the market.
Other Risks
Obviously there are many factors that have a bearing on the price of crude oil; I would need to write for another year or two to name them all. The factors I have laid out are the most commonly talked about factors, but by no means necessarily the most important factors. One time events generally have an effect on the markets, as well as events that surface every so often. A good example of this is the potential problems and conflicts involving the Strait of Hormuz.
This strategically positioned strait is located between Iran and Oman and is probably the single most important geographical location in the world in regards to crude oil pricing. Because of the vast amount of crude oil production coming from the Middle East, it is estimated that roughly ~40% of the world’s crude oil travels through this strait on a daily basis. If anything were to happen to the strait, the crude oil markets would be in complete meltdown. The realization of this threat has never been real, until recent threats from Iran’s President Mahmoud Ahmenijhad mentioning sinking Iran’s own oil tankers to block the strait in order to inflict financial pain on nations who rely heavily on crude oil.
Luckily the United States has a naval fleet stationed full-time near the strait, but that does not necessarily mean that an attack could be averted. Certain special situations such as this hypothetical scenario will generally have an upward effect on crude oil.
Final Thoughts
Obviously the information presented above and in this set of articles is an extremely large collection of information that is only a relatively small piece of the entire puzzle. The market in many cases is fairly efficient and there are other factors priced into crude oil that no one can even begin to understand. As I have stated above, there is no set equation to determine what a barrel of crude oil is worth but I think it is very apparent that if there is an overriding factor, it is the all encompassing supply and demand equation. Even this seemingly simple concept is almost impossible to map when it comes to crude oil, and all of the other variables make the real equation unknown.
There are many great sources for information on crude oil, especially in terms of history, pricing, and how macro economics affect crude oil. If you are interested in learning more about crude oil and its rise I would highly recommend reading the book The Prize: The Epic Quest for Oil, Money, and Power by Daniel Yergin. This Pulitzer Prize winning book is the most accurate and in depth description of the history of crude oil as well as the macro economic ideas that are important to the past, present, and future of the commodity. The book is over 900 pages long but it is one of the best books I have ever read and for anyone invested or planning on investing heavily in energy stocks it is a must read.
I believe that there are three important things to remember: firstly, over the short term and sometimes intermediate term, the fair value for a barrel of crude oil is what the market says it is and nothing else. Secondly, the market does not always digest information in the fashion that seems the most logical. Often times new information will surface that would seem to be bullish or bearish for crude oil and the price will react in the exact opposite manner.
This may occur because there are other factors at play simultaneously: other investors do not come to the same conclusions from the same information, or for other reasons that are seemingly illogical. Finally, as much as you or I may think that we know about crude oil and its market, there is an even larger amount of information that we do not know.
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