4 Ways to Ride Oil's Ups and Downs

Oil is trading well over $70 a barrel - at its high for this year, and just off its nine-month high of $73.20, seen last October 21, oil has been steadily rising. Oil prices have risen nearly 100% since their $38 a barrel lows seen last January.

Unfortunately, at a time when consumers can’t afford a wallet drain, retail gasoline prices across the United States have risen to $2.55 a gallon on average, and over $3.00 a gallon in places like California.

As you drive by the gas station and see the now familiar price changes - sometimes by the hour - you might wonder what’s really affecting the price you pay…

Investors, of course, want to know if there’s a good way to play the price moves. Let’s take a look at the two biggest drivers of oil prices and ways you can play its movements.

Oil Prices Rise As Production Costs Vary Widely

As with any natural resource we use, crude oil has costs associated with its production that are relatively clear, but nonetheless can vary widely.

Those variations come about almost entirely based on where the oil is. Since we’ve been using the black goo for nearly 100 years, it stands to reason that most of the easy, cheap oil deposits have already been found.

Taking a look at the costs to even find the stuff:

• You’ll find deep-water exploration is far more expensive than land-based exploration. You need a sizable exploration vessel, capable of operating in some of the world’s angriest oceans for months at a time. It has to be equipped with highly sophisticated instrumentation and software to be able to “see” potential crude oil deposits as deep as seven miles below the surface of the ocean. You also need a crew of mechanics to keep it all working, and petroleum engineers and geologists to interpret the data.
• Land-based exploration - on the other hand - can be done from a well-equipped van, by one or two petroleum geologists. Then there’s production costs: land based oil is cheap to drill for. Land-based drills can fit on the back of a few tractor-trailers and can be torn down, moved and setup at a new location with relative ease. In addition, it’s much less expensive to extract.

Land based production is definitely preferred. Unfortunately it’s not where the big new finds are made.

As you go offshore into deep water, things get expensive fast: deep-water extraction is a financially losing proposition with prices anywhere below $75 to $80 a barrel, compared to as little as $25 to $30 a barrel for some land-based deposits.

But exploration isn’t the only cost of crude oil. Refining, transportation and taxes make up the remaining cost of what you pay at the pump. And that’s really just the start of what we pay for gas…

The Other Price Drivers: It’s Not Always What You Think

When crude oil prices spiked to $147 a barrel, there was no question that speculation played a significant role in getting it there. But speculation also played a role in getting it to $38 a barrel, too.

In the end, for oil and just about everything else, it all comes down to supply and demand. We’re in a recession, and demand continues to slacken. OPEC’s response has been to cut supply, with the thought that - everything else being equal - prices would eventually stabilize at some level.

But everything else isn’t equal: The Federal government has been dumping cash into the financial system at unprecedented levels. It’s caused the dollar to drop in value with respect to other world currencies and with respect to gold.

Since oil on all the world markets is priced in dollars, its price rises as the value of the dollar declines. It’s one of the reasons many oil-producing countries have suggested that the price of oil be tied to a basket of currencies instead of just to the dollar.

Unfortunately, there aren’t any other currencies that are as abundant or - more importantly - strong enough to handle the sheer volume of the transactions that occur daily in the oil market.

So we have demand and supply destruction in a race downward here in the United States that’s kept oil inventories high - up until a few weeks ago. Add to that steadily rising demand coming from emerging markets around the world. Throw a declining dollar into the mix and stir.

The result is rising oil prices - in all likelihood heading to $80 a barrel or possibly even higher by the end of the year.

Three Ways to Play the Pickup in Crude Oil Prices

As for investing in crude oil, here are three ways to get long in oil and one way to short it:

• Certainly one of the big drillers like TransOcean (NYSE: RIG) is a great long-term play on rising oil prices, as their shares closely mirror the rise and fall of the commodity itself. Shares of the drillers have been absolutely punished, and TransOcean is off nearly 50% from its 52-week high.
• The United States Oil Fund LP (NYSE: USO) is an ETF designed to track West Texas Intermediate (light, sweet crude oil) prices. The fund invests in futures contracts for crude, heating oil, gasoline and other petroleum-based fuels.
• If you don’t mind some potential added volatility, PowerShares DB Crude Oil Double Long ETN (NYSE: DXO) is a long-leveraged Exchange Traded Note available to investors. It’s designed to track the performance of certain crude oil futures contracts, plus the returns from investing in three-month Treasuries.
• But if you’re a bit more active in your trading, or if you feel oil is ready for a pullback, you might consider a short approach. PowerShares DB Crude Oil Double Short ETN (NYSE: DTO) is designed to do just the opposite of DXO if you feel that our current rally in oil prices is overdone. For the reasons above, I don’t believe that’s the direction we’re going, but I think DTO is one of the better ways to play a short approach to oil.

Any way you play it, you need to be aware that there are many factors that can affect oil’s price, and by extension, any investments you have that are tied to it. Keeping an eye on the biggest drivers of these prices will give you a leg up on the average investor.

Comments

[Shale Gas:]

What are your thoughts on natural gas?

Jun 12 10:13 AM

[TurtleTrader72:]

Fibonacci retracement studies support the authors comment that oil could be going back up to about $80 per barrel over the short. Use the weekly charts and measure from the intraday high of $147.90 to the intraday low of $35.13 and this should provide you with first retracement level (38.2%) at around $78.21. This is not to say that the trend will be straight up, but it gives you an idea that oil (although up significantly up from the low) may still have some room to the upside. Personally, i think $80 would the high point, at least for this year. Next year is anyones guess. I am big believer that the recent rise in the price of oil has much to do with the decreacing value of the US dollar. Overalying the charts will visually show the inverse corralation. However, unlike many people I am not all that bearish on the US dollar, athough there may be some more downside in the eshort term. With that being said, i do not that feel that these oil prices will be sustained over the intermediate term. I don't believe that there has been any recent increase in demand that could justify these higher levels. At least for the moment, oil is driven by the US dollar and as the US dollar starts to show some strength oil prices will fall.

Jun 12 10:58 AM

[TurtleTrader72:]

Technical speaking, the trading pattern suggests the Natural gas will move lower over the short and/or intermediate term. The recent trading pattern has formed what is called a 'symetrical triangle' which tends to be a continuation pattern. Unless the price gets back up above $4.60 or so I would remain bearsih on it.


On Jun 12 10:13 AM Shale Gas wrote:

> What are your thoughts on natural gas?

Jun 12 11:23 AM

[Maxe Paul:]

It always amazes me at how extreme risk and leverage has made a bigger comeback than oil ATM, i mean why would anyone want to trade (sorry gamble) with double leverage on oil?

It's the most volatile commodity to trade already!

Even the ETF dudes have not brought out a 3 x leveraged oil product yet, but mark my words, their thinking about it!!

Jun 12 11:27 AM

[Marco Hickey:]

I am still sticking to what I wrote a few weeks back about crude peaking in mid July. I have been riding my option calls spreads and will start taking profits as we see 75-78 a barrel. I think we may see crude at 80-85 a barrel by mid July.

Jun 12 02:00 PM

[Stephen Yu:]

The ratio of oil/natural gas price is near 18. According to Bespoke, each of the three times this ratio topped 18 in 1990-'91, it proved a good time to bet on gas relative to crude. Twice, the subsequent outperformance of gas was dramatic, the other time merely impressive. On an BTU per dollar basis, a proper ratio (I call it the energy-equivalent ratio) is closer to 6. So if oil trades at $60 a barrel, gas should be at $10. Granted, oil and gas aren't the same. Oil is used mostly in transporation, whereas gas is used in power plants. Also, the infrastructure for gas is not as well established as it is for oil. So it is not a surprise that gas trades at a discount to oil. Yet, these characteristics do not explain the wide gap between the present oil/gas ratio of 18 and the energy-equivalent ratio of 6. Furthermore, while oil has retrenched about 50% from peak, gas has fallen nearly 75%. It is quite obvious that the plunge in gas price cannot be justified by slowing demand. Finally, production costs at some natural gas producers are now above the current gas price. So if natural gas price stays at current level, producers will cut back production thus reducing supply and pushing price up.


On Jun 12 10:13 AM Shale Gas wrote:

> What are your thoughts on natural gas?

Jun 12 03:28 PM

[BioBoy:]

I am surprised to hear you recommend USO. It may be "designed to track West Texas Intermediate (light, sweet crude oil) prices", but it doesn't. It's underperformed by 14% in the past year. How about recommending something useful, like DBO? Unlike USO, which simply rolls over near-month contracts (and usually takes a loss each and every month doing it), DBO buys a variety of far-month contracts to minimize the effects of contango. Compare their performance and you'll see the difference.

Jun 12 09:30 PM

[jfrits:]

Bernanke is like panic-stricken amateur pilot trying to crash land a 747, ergo, the spike in interest rates this past week; slamming on the brakes to stop the dollar from going off a cliff. the chinese were buying oil and other commodities like crazy with the buck free-falling.
but they, like other asian govts. are very price sensitive, and the recent demand for stocking up on oil and other commodities in the emerging markets could vaporize as oil tops $70. meanwhile the summer driving season is a bust, so i heard on fox business today that valero has just shut down a domestic refinery due to lack of demand for gas. so the chinese and others will return to buying u.s. paper for the windfall higher yields. so my guess is lower oil prices by winter, not higher, say $40 bucks give (+10) or take (-5)?
i could be wrong. iran and israel could stumble into a nuclear war, there could be a nigerian govt. coup, etc. etc. but then would not oil be boring if not trading on riveting world political developments? bring on the 3x direxion crude ETFs! trade on!

Jun 12 11:30 PM

[Fairway Jack:]

Agreed...USO is a joke. Contango erosion wipes out any semblance of a true reflection of tracking oil prices. Steer clear of this fund


On Jun 12 09:30 PM BioBoy wrote:

> I am surprised to hear you recommend USO. It may be "designed to
> track West Texas Intermediate (light, sweet crude oil) prices", but
> it doesn't. It's underperformed by 14% in the past year. How about
> recommending something useful, like DBO? Unlike USO, which simply
> rolls over near-month contracts (and usually takes a loss each and
> every month doing it), DBO buys a variety of far-month contracts
> to minimize the effects of contango. Compare their performance and
> you'll see the difference.

Jun 12 11:46 PM

[svosavvy:]

We haven't drilled to china yet so there is still plenty of oil left in the ground. Technology will bring new ways to get it. I am still wondering why the eia has such a small reduction in the demand for oil. We are staring at 10% (realistically we should pray for 15% only when all is said and done) unemployment in other words nowhere to go and no money to get there. Which is a pollyanna number. Industrial jobs not only are scarce, but, if you take a 50% haircut in your wage/hr or a 50% haircut in your hours it still means half your 2007 wage (but still employed lol!). EIA says we are only going to tail off a couple million barrels a day from 84 million/day. These guys are smoking more ganja than Bob Marley. Flat to negative demand and still tankers parked in the gulf brimming with oil, come on now really.

Maxe paul if you want a triple levered oil play try the erx triple energy bull or the ery triple energy bear. Pretty thinly traded (illiquid) so you could also catch the bid/ask sucker spread. It's like the x games sooner or later someone will find a bigger better bridge to base jump from.

IMHO near term crude at $80 will make a nice backside head and shoulder. Long canroy's at fire sale prices when we hated oil, and short them recently through sold calls when we have recently fallen in love with oil again.

If the fed even hints at pulling in the money supply this inflation party is over before it started. Never has a population been so cognizant of its money contraction/expansion. Our balance sheet was massively expanded on 9/12/01 and no one batted an eyelash because we were at war. When the time was right say mid 2000's to contract the balance sheet, I can believe the administration was quite pleased with itself and the "value" they had created the let their winnings roll.

Jun 13 12:39 AM

[Shale Gas:]

Turtle...I appreciate the technical perspective, but I was also interested in the fundamentals of natural gas.

Jun 13 05:42 PM

[Ellito:]

Don't kid yourself,
there is no way to ride oil.
Or anything else in that matter.

Jul 17 12:42 PM