An Insider’s Look At The Oil Trade

Let’s say you’re an oil company manager planning an offshore development. You have to think long term. It can take 10 or 15 years to go from prospect to producing platform, especially in the deep offshore. But do you really know what the price of oil will be a decade from now? C’mon… nobody knows that. The point is that there’s a lot of hope and prayer in a long-term oil-development capital investment decision like that, and informed speculation.

But if you’re an oil trader, you think more short term. If you trade “paper barrels” for profits, you might move in and out of oil contracts based on daily and weekly postings. You watch for quick moves in oil prices, because those trends will make or break you.

If you trade futures for actual supply — such as a refinery or a large user like an airline does — then your time frame goes out several months, up to a year or so. It’s critical to get things right, because if you make your contract in the wrong direction, it’ll control downstream profitability in a big way.

The Last Three Months

So how does an oil trader focus? What’s important? There are many factors, of course, but let’s look at a three month chart for Brent Crude — the foundation of many international contracts.

Oil prices traced a decline that began in April and continued into May and June. Oil prices fell from the $125 per barrel range in April to $90 in late June, a drop of about 28%. Then prices took an upturn at the beginning of July. Big moves like that lead to big leverage. As you can see, there’s quite a spread within this chart over time.

This three-month chart is eye candy for a seasoned trader. If you knew (or, as a trader, suspected) in April that $90 was the new $125, then you could have made serious money by buying and selling the right kinds of contracts. In other words, you can make money on both sides of the trade.

Looking back, what caused the recent oil price swoon and recovery? Was there a big oil surplus in the late spring? Were there oil supply disruptions at the end of June? Were there any new demand developments? Well, you lived through those months too. What do you recall?

Basically, nobody blew anybody up — except for the civil war in Syria, which is not a major oil player. It’s not as if rumors of war in the Middle East came true. Israel didn’t attack Iran. Plus, there were no major weather events or disasters that impacted the oil sector. The tankers sailed. The sea lanes remained open. If you wanted oil, you could have bought it.

So what pushed oil prices down in the spring, and then lifted them back up in July?

In spring 2012, the consensus was that economies across the world were weak. The news flow focused on ongoing issues within Europe, the China slowdown and the lack of momentum in the U.S.

On the supply side, there was significant extra oil output from Saudi Arabia in the spring, leading up to the July 1 date for sanctions against Iran.

Looking back, future expectations controlled oil pricing, as opposed to the realities of production, transport and supply. That’s expectations, and NOT any physical issues of supply and demand. But those perceptions made for a $35 spread over just a couple months, from $125 to $90, and then back up. It’s big money, considering that “nothing” really happened.

Looking Back Five Years

So as we saw above, in the short term, oil prices have moved significantly. But now look at that same three-month downtrend as part of the past five years.

Last winter’s $125 oil price was abnormally high, if you look at the broad trend. That $125 number was unusual, and hardly a “new normal.” We’ve seen Brent oil at $125 only a couple of times over five years.

Yes, if the Middle East goes to war, or if there’s another big blowout and offshore moratorium or such, then we’ll have a major supply disruption. But absent physical interruption, in an overall view, it’s not hard to conclude that oil prices at $125 are too high for the current global situation.

In fact, the $125 price level from last spring was destined to fall. (I said as much in a number of articles and media interviews.) The only question was by how much.

Still, the drop from $125 to the $90 range was remarkable, and quite fast. Part of the plunge may have reflected selling momentum on the way down — people bailing out of contracts in a panic.

There was also an element of market psychology in the price tumble. Many investors anticipated a major economic collapse in Europe, if not China or the U.S. Indeed, at the recent Agora Financial Investment Conference in Vancouver, one of the consistent themes was “apocalyptic” thinking and planning. At one session, Rick Rule asked me how much “apocalyptic thinking” goes into my newsletter editorial process.

As you likely noticed, we dodged the apocalypse… at least over the past three months. But maybe next quarter? Gas up the generator, clean the guns and put some oil in the locks on the underground bunker, eh? Then again, who knows?

Let’s get back to the original topic. When you look at oil prices, you need to look at things both in the short and long terms. You want to balance your viewpoint over time. Then you’ll begin to discern clues to investing in energy trends — and many other market trends, as well.

Pricing Points

Let’s get back to late June, when $90 formed a floor at which oil prices began their recent bounce. There are several reasons for the price floor for Brent at $90.

One reason is that many oil-exporting nations need $90 or so to bring in enough income to balance their national accounts. Absent $90 oil, some nations can’t pay for food imports, let alone keep the army and secret police living in style.

Then there’s the issue of “finding cost” for oil. When you add up all the inputs, what does it cost most oil companies to locate new resources? Each company has its own set of books, of course, but the global average is in the $80-plus range to “find” a new barrel of oil. So add in the return on investment, and there’s your $90 floor as well.

Why the $147 Price in 2008?

Here’s something else to consider. Go back to the five-year chart. Look at that price run-up back in 2008. Oil prices rocketed upward and spiked to $147 per barrel in July. Then prices crashed down to the $40 range. What happened?

Well, we learned that the world economy does NOT work when oil is $147 per barrel. It’s the precursor for economic disaster. At $147 per barrel, the world’s transportation system seizes up like a clogged artery in the heart of the global economy.

Aside from that obvious point about expensive fuel, was the $147 run-up really due to the overall craziness of the crazy pre-crash market, and especially those evil oil speculators? Yes and no.

The fact is that Saudi Arabia had production difficulties in the first half of 2008. The Saudis had issues lifting enough oil to satisfy a strong market. Of course, the always taciturn Saudis didn’t admit it at the time.

Then, in a truly one-off event, the Chinese stockpiled oil in the lead-up to the 2008 Olympics. Really, the tanker sailings support this idea.

So here’s what happened in 2008: China overbought oil, and Saudi Arabia underproduced it. The traders chased the disparity and didn’t truly appreciate what was going on. So oil prices rose into the ether. There was your $147 oil.

That early 2008 oil price run-up was rooted in a China demand and Saudi supply stories that never really made it into the headlines. Yet the price run-up helped trigger the 2008 crash — it wrecked the economics of the global airline industry, for example — which then took on a life of its own.

Now look at the oil price recovery in 2009 and 2010. Those were the days of government bailouts and Federal Reserve “quantitative easing” (QE), remember?

As you look at the chart, it’s clear that oil prices bounced around $80 per barrel in 2010 and $110 per barrel in 2011. I’ve talked with analysts who believe that two-thirds of that price differential — $20 of the $30 difference — was due to the saber rattling between the West and Iran over the latter’s nuclear weapons program.

Not Just a Number

The take-away here is that the price of oil isn’t just some number on a chart. The oil price reflects many things about the current and future prospects for the world economy, and world politics. It reflects supply realities and expectations for the future.

And oil prices certainly control the share price destiny of energy and energy service companies, as well as mining and related companies.

I’ll end here. Thanks for reading.

Byron W. King

An Insider’s Look At The Oil Trade was originally featured in The Daily Resource Hunter. Check out the newest Daily Resource Hunter research video “The Price of Gas Explained”.

Article Title originally appeared in the Daily Resource Hunter (www.dailyresourcehunter.com) At the Daily Resource Hunter our approach to research is different. With our boots on the ground, we travel the world looking for the most lucrative resource opportunities and deliver them to you in a daily email newsletter. For more information visit us at www.dailyresourcehunter.com)