The Price of Oil: Where it’s come from, where it’s been recently, where it’s going, and how to play it After a sharp, almost unabated move from $50/bbl in early 2007 to $147/bbl in July 2008, the price of crude oil has fallen off sharply, settling under $107/bbl at the close of business on Friday. Put another way, after a 200% spike in eighteen months, crude oil has dropped nearly 30% in seven weeks. So this begs the question: is this 30% decline only the beginning of the shape of things to come or is it an excellent buying opportunity for oil or is it an excellent buying opportunity for pure refiners? My answer may end up being an unsatisfactory ‘wait and see’, but I will attempt to arm you with all the necessary information and analysis, so when that moment comes, you’ll be ready to move. To really understand how we arrived at this point it is necessary to be educated on where oil prices have come from and what has caused the sudden and sharp pullback. First, the ancient history: The past five years. In 2003, oil prices averaged $28/bbl. This was probably the last year of the ‘old’ paradigm for price determination in the oil markets. Until this time, the oil market was a supply-dictated market. It was supply-dictated because there was excess capacity in the market. Put another way, if The ‘new’ paradigm for price determination in the oil market started in 2004 as The recent 30% decline. To varying degrees, the following are five reasons for the seven week slide: Stephen Rodenbeck
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This ‘new’ paradigm is responsible for the super spike in oil prices to $147, not hedge fund speculation or the Saudis holding back supply. Speculation can happen in very short spurts, but over the long haul speculation can only have a muted impact as speculators will be faced with the prospect of taking delivery – something that almost no speculator can do – and thus will be forced to sell the futures contract before it expires. On the other end of the oil market continuum, the Saudis have been ‘accused’ by various sources – the Economist comes to mind -- of holding back excess supply of nearly 1.3 million barrels a day. That ‘excess capacity’ is comprised of heavy, sour crude that no country wants and very few refineries in the world can process at any price. It would be like saying I have 11 million barrels of water, 9.7 million of which is potable, and 1.3 million is ocean water. Does the 1.3 million actually count as ‘excess capacity’? The ignorance on this subject spouted by ‘reputable’ media sources is nothing short of amazing.
What’s Next? Now that we have a better understanding of how oil prices arrived at their current destination, where do they go from here? Of the five reasons above, the two that will be most helpful towards achieving that end are the increase in OPEC production (reason #3) and the possibility of a world wide recession (reason #5). Predicting how currency markets will react to a weakening Europe (reason #4) versus the struggles of the
What is now important: with the quick drop in demand for crude coupled with the uptick in supply from OPEC, the market has created the illusion of temporarily swinging from demand-driven back to supply-driven. In a supply-driven market, I would expect OPEC to defend $100 oil by cutting back on oil production if necessary. So at $107 a barrel, it does not look like there is much downside in crude prices. [The reason I use the term ‘illusion’ is that despite the recent uptick in OPEC production, worldwide crude oil (and total liquids) production hasn’t increased meaningfully over the past three and a half years despite the massive move in crude prices.] However, as the economies here and in
The answer to that question probably lies in the construction of the futures price curve. For the sake of education, let’s digress for a moment. When the price for a contract month nearer to the present time is higher than the price for a contract further into the future, the market is said to be in backwardation. Typically, this means that prices are high because current supplies are tight. Conversely, when the nearby price is less expensive than the farther-dated prices, the market is in contango. A crude oil producer (or refiner) with excess storage capacity can make money when the price curve is in contango by purchasing the cheaper prompt month (or spot) and selling the more expensive deferred contract month. The producer (or refiner) is thus being paid to store oil. When the markets are in backwardation, however, spare storage capacity is an asset that generates no cash flow. (A good way to track the futures price curve can be found at http://futures.tradingcharts.com/marketquotes/index.php3?market=CL)
The markets have more or less been in backwardation for the past eighteen months. However, just recently, the oil market has gone into a slight contango. If this situation persists, look for storage levels worldwide to increase as refiners and producers are being paid to store crude. This increase in oil stocks could satiate any increase in demand caused by the recent 30% downdraft in prices or a resumption of normal demand levels in
So to conclude, if the markets move out of contango and back into backwardation, look for attempts by OPEC to defend $100 oil to be successful; thus, oil is a buy. If the markets remain in contango, look for storage to build and look for oil to struggle to maintain current levels. Unlike the backwardation scenario, where I think oil is a safe buy, the better way to play the storage build (or contango) scenario is to buy the refining stocks (such as Valero (VLO) and Tesoro (TSO) instead of selling oil. These stocks have been absolutely decimated by the recent spike in oil prices and the collapse in crack spreads. To illustrate, let’s say that a refiner buys oil on the spot market at $90. After the oil is refined into its end products (gasoline, jet fuel, asphalt, heating oil, etc.), the refiner receives the equivalent of $100/barrel for the finished goods. However, as it receives the $100/barrel for the finished goods, it must go out and purchase more crude to refine. In a the hyperbolic marketplace that defined the first six months of this year, refiners may now be forced to pay $110/barrel for the next batch of crude oil. So they are collecting $100, but having to pay out $110 in order to continue refining.
In addition to the squeeze brought about by rapidly rising oil prices, refiners are getting crushed by crack spreads. The crack spread is the differential between the price of crude oil and petroleum products extracted from it. Using July 2008 as a benchmark, the price of WTI crude oil had jumped 100% in the prior year, but gasoline prices only moved up 38%. There are many reasons for this, but one of the major factors is that fully integrated oil companies (such as Exxon) don’t need high gasoline margins to keep profits at an acceptable level. Those conglomerates will make enough on the huge run up in the price of oil and don’t have to be as concerned with making big refining margins. As a result, refiners that are not part of a fully integrated major are getting crushed on margins.
With the recent collapse in crude prices, refiners are getting the benefits of selling finished products at relatively higher prices and buying new inputs (crude) at cheaper prices. In essence they sold finished products at some premium to $147/barrel in mid-July, but are now purchasing new crude at $107/barrel. If the markets stay in contango, these refiners will also make money storing oil which will act as a counterbalance to the squeeze from the narrowing of the crack spread. Keep in mind that these refining stocks have large debt service ratios, but the risk/reward profile for them in a contango market makes them very compelling. So remember, at this point, backwardation in the futures price curve is a signal to buy oil and contango is a signal to buy the independent refiners.
From the Most Award Winning Small Batch Distiller in America
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