Three Items That Will Signal a Crude Recovery

One of the questions that I have been asked a lot lately is why oil is so cheap today, when only a few months ago it was ridiculously expensive? Part of the answer has been provided in the question; it was ridiculously expensive and despite what every ‘analyst’ on CNBC said, there was no fundamental reason for oil to be $147/bbl. The fundamentals probably stopped making any kind of sense around $75-$85/bbl, so the question is really, why is oil 50% off that price?

What really needs to be understood is that the ‘price discovery’ mechanism for WTI (West Texas Intermediate) crude is NYMEX. One NYMEX WTI Crude contract is 1,000 barrels of oil, delivered in a specific month to Cushing, Oklahoma. I am not a futures trader, so I may have messed this up, but I think the initial margin for one of these contracts is $9,113 (assuming you aren’t a member; if you are a member it is $6,750). That means with $38,000 of exposure (at today’s prices), the average member can use about 5.6x leverage with futures contracts.

The reason why WTI keeps dropping in price is because inventories keep increasing. When inventories increase, traders take it as a sign that demand is low and there is plenty of willing supply at these prices; therefore, the price of oil should go down until inventories stop building (i.e. demand equals supply).

The truth of the situation is easy to understand (but doesn’t fit in a headline as nicely); contango (when you can sell a commodity at a higher price in the future) forces crude into storage. Why sell your crude today for $37 (or in February for $38.79) when you could sell it in March for $45? Obviously you wouldn’t, you would just pay for storage and sell it in March. So long as there is an extra wide contango in crude, we will see inventories build, which leads traders to sell crude (which leaves us in a never ending downward spiral).

The contracts for February delivery have 151 million barrels of open interest, and 333 million barrels of February oil traded (closing price $38.79) yesterday. The March contract has 276 million barrels of open interest, and 235 million barrels of March oil traded (closing price $45.01) Tuesday. That’s trading for 1 day, keep in mind that we only use (across the whole planet) 85 million barrels per day. So the market trades (when you add in the other months) about 8 barrels of WTI for every barrel of oil (not all oil is WTI) that actually gets used. I’m skeptical that a 6 million barrel inventory build in a week (about 4.2% of US weekly demand, and about 0.1% of WTI trade volume) has any actual bearing on what the true demand/supply fundamentals of the oil market are.

We’ve already established that contango puts crude in storage, but not why it keeps falling. There is definitely an excess amount of supply of crude; none of this would be an issue if supplies were as low as the spring (when China was stockpiling for the Olympics). The real issue is why contango is so wide in the first place. When you are in the middle of the worst credit crisis in history it may not be a problem to have an open contract (where you only need 1/5th of the notional value of the trade), but it is a serious problem to accept physical delivery (where you need to pay 100% of the notional value of the trade). So traders are speculating that the price of crude will go up in the future, but every time a contract becomes the front month (February now), the price drops like a stone because the risk of taking physical delivery increases.

The select few who have the financing and the ability to store crude will take delivery (at this new discounted price) and sell a future contract for a guaranteed profit. It also allows producers who have a higher marginal cost (like $50/bbl) to continue producing, since they can sell their production forward (say to September) at higher prices ($56.05).

What all that means is there are a few things to look for that will set the stage of a crude recovery:

1. Thawing of the credit markets (which is already well under way). If people could get financing for the carry trade on crude that would drive front month prices up and later month prices down (removing some marginal supply).
2. Increased demand. This is obvious, more demand could reduce some of the excess inventory.
3. Decreased supply. We are already starting to see a decrease in supply from OPEC nations.

Any of those three things could spark a recovery in crude. It’s worth noting that two of them are already well underway (although we won’t see the results until it’s probably too late). So why is crude so cheap?

Disclosure: Author holds long positions in oil related equities.

Comments

[Ishortyou:]

Time to invest in other energie technologies the dark age fossile fuel energy standard is now a big prolbem.

Jan 15 07:23 AM

[Perry1961:]

The US imported 2.1M bpd less in November than it did in October. At the same time,inventories of refined products,as well as crude in storage,were building. It appears that demand just dropped off a cliff in Q4. If other OECD countries suffered similar drops in demand,OPEC cuts were too little,too late. Today's prices gave Americans sticker shock just 5 years ago. And that was when the economy was firing on all cylinders. Never mind that the marginal cost of production is higher than current prices. Once a well is operating,it's hard to give up the cash flow. Producers need to cut another 5M barrels a day to maintain current prices. I don't see that happening overnight.

Jan 15 07:28 AM

[Perry1961:]

Crude oil imports dropped to $17.45 billion from $29.83 billion in October. The value of oil imports fell so sharply because prices plunged and use plummeted. The average price per barrel decreased by a record $25.30 to $66.72 from $92.02. The volume of oil imported declined to 261.60 million barrels from 324.19 million.

online.wsj.com/article...

Japan Oil Imports Fall 17% as Recession Damps Demand

www.bloomberg.com/apps...

The 5% cut OPEC is trying to implement is obviously a drop in the bucket.

Jan 15 07:40 AM

[Hefaistos:]

Your three indicators for a crude recovery are'nt very precise. I would add one, leading indicator:
4. A decreased level of contango would also by itself indicate a market stabilisation, in the current situation it would mean that spot market supply is soaked up by demand, and not just stored away. So, look out for a levelling out between spot mkt price and future mkt price

Jan 15 08:08 AM

[yank:]

It's not a 5% cut. It's actually closer to 9% according to Bloomberg.


On Jan 15 07:40 AM Perry1961 wrote:

> Crude oil imports dropped to $17.45 billion from $29.83 billion in
> October. The value of oil imports fell so sharply because prices
> plunged and use plummeted. The average price per barrel decreased
> by a record $25.30 to $66.72 from $92.02. The volume of oil imported
> declined to 261.60 million barrels from 324.19 million.
>
> online.wsj.com/article...
>
>
> Japan Oil Imports Fall 17% as Recession Damps Demand
>
> www.bloomberg.com/apps...;sid=aARtW1Jc4QZo
>
>
> The 5% cut OPEC is trying to implement is obviously a drop in the
> bucket.

Jan 15 08:45 AM

[silver-bullet:]

Consumer sentiment needs to be up too. This will happen with increase of jobs and economic activity. Both of which are not happening.

I truly believe energy and hard assets are the place to be - in the long run. However, the timing is absolutely critical. Unless you have extra capital to burn in the medium term (1 to 2 years), you want to save it for a rainy day.

Stay safe.

Jan 15 08:48 AM

[Mmarrkk:]

Perry: you fail to include depletion. If the world is producing 80 mmb/d and a conservative estimate of 5% depletion is occuring, that means by the end of the year we will have lost 4 mmb/d. So we'll have to replace that 4 but with prices so low, there will be fewer and fewer projects brought on line. Expecting any ramp ups in Canadian oil sands?? Yes, there are some ongoing projects which will be completed and will come on. But look at the massive budget cuts being announced by all of the oil companies. New projects are being slashed. So it may take a year or so, but I think you'll see supply getting back into balance in 2010, if not earlier. And that assumes the world's economy stays in the crapper. If it inches up, expect that balance to occur a little earlier...late 2009.


On Jan 15 07:28 AM Perry1961 wrote:

> The US imported 2.1M bpd less in November than it did in October.
> At the same time,inventories of refined products,as well as crude
> in storage,were building. It appears that demand just dropped off
> a cliff in Q4. If other OECD countries suffered similar drops in
> demand,OPEC cuts were too little,too late. Today's prices gave Americans
> sticker shock just 5 years ago. And that was when the economy was
> firing on all cylinders. Never mind that the marginal cost of production
> is higher than current prices. Once a well is operating,it's hard
> to give up the cash flow. Producers need to cut another 5M barrels
> a day to maintain current prices. I don't see that happening overnight.

Jan 15 09:04 AM

[Ferdinand E...:]

Interesting article, and very professional. But that doesn't mean that it is necessary to agree with all of it. I'll never agree for instance that the fundamentals stopped making sense when the price of oil was $75-80/b. Why should OPEC accept that price at a time when demand was steadily increasing, and their were no visible glitches in the international macroeconomy - except of course to persons who were later pronounced geniuses. There are also some 'causality' issues in the picture. Maybe you should check the chapter on derivatives in my textbook THE POLITICAL ECONOMY OF WORLD ENERGY.

Jan 15 09:35 AM

[CLH:]

Ferd---" Why should OPEC accept---" this statement makes no sense. OPEC has absolutely nothing to say about the price of oil. Oil is market driven and OPEC is not a monopoly. Although it would like to be.

Jan 15 12:46 PM

[arbormed:]

You are right, of course, but why not look at O&G Trusts, say, as a way to get a good return while waiting for the economy and sentiment to turn around? At current prices, these Trusts won't throw off 13%, but they will beat the piddling 1-3% available elsewhere. And, you own something that will not be devaluing like the dollar, and you still have the price appreciation when the turnaround comes.

I am long HGT and SJT. Obamanos.




On Jan 15 08:48 AM silver-bullet wrote:

> Consumer sentiment needs to be up too. This will happen with increase
> of jobs and economic activity. Both of which are not happening.<br/>
>
> I truly believe energy and hard assets are the place to be - in the
> long run. However, the timing is absolutely critical. Unless you
> have extra capital to burn in the medium term (1 to 2 years), you
> want to save it for a rainy day.
>
> Stay safe.

Jan 15 02:18 PM

[scotty1560:]

oil like equities, real estate, gold, credit, etc..might have hit a generational peak..these events could take 15-20 years to cleanse...look at Japan's equities...gold in the 1980's....US equities in the 1929-1950 time line....

the boomers have peaked on consumption in the US and much of the post
WWII countries....will take till 2020-2025 to see the next major boom....
watch your cash..be careful of your banks and a bank holiday at some point..

that said I own USO...hoping for one good rally in the next few months..
since I'm in the peak oil camp...will keep a core holding as insurance
for peak oil or the possibility of inflation hitting commodities...

Jan 15 08:54 PM

[Conan the B...:]

Remember the War Premium that was built in with the Iran/Israel saber rattling during oil's run up last year?

It could be that Oil now has the Depression Demand Destruction negative being built in to the nearby contracts.

Will GDP in the first quarter be negative also?

Jan 16 11:08 AM