Betting On Oil? Pay Close Attention To The Facts

Nothing loses you money like aphorisms. “This time it’s different” is a favorite, but another good one is “Buy the rumor, sell the news.” Well, in the case of oil, you may want to stick to it.

Oil, unlike, say, gold, is a commodity of utility; not only do we need it to keep warm at night, but it’s not hyperbole or penmanship to say that it fuels most of the world’s economies. Nobody except OPEC and Hugo Chavez really thinks this is a good long-term plan for the human race, but it’s the real world.

It’s also, on the short term, a relatively predictable asset. A predictable amount will come out of the ground tomorrow, and the day after that. Get too far on that train of thought and you’ll have to delve into the peak-oil world, but it’s safe to say that we know where it’s coming from, we really know where it’s going and we know exactly how to get it from A to B. The infrastructure for moving petroleum around the world is more efficient and less prone to error than your Internet connection.

Most economists would tell you that such an efficient, highly liquid market would be somewhat immune to misinformation; after all, there are so many players, all of which know something; collectively, the market must know everything, right?

So why then do oil prices send headline writers looking for better explanations than “Oil futures plummeted on the meditations of a voodoo witch doctor in Des Moines?”

Because the dirty little secret of oil is that it trades more on information than it does on supply and demand. The driver of oil prices is not the barrels actually available on that proverbial loading dock in Cushing, Okla., but rather, on how likely it is that the same number of barrels can get there tomorrow. Because, as a commodity of utility, they have to be there tomorrow – almost no matter the price.

Let’s look at the replay, courtesy of WTRG Economics, an energy analytics group:

We all know that oil prices go up when there’s unrest in the Middle East, right? Everyone knows that. But when do they go up?

There are really only a few times in recent memory when we can say “AHA! Now THAT was a supply problem.”

Back in 1973 there was a little scuff-up in the Middle East you may remember as the “Yom Kippur War.” For a variety of reasons, world oil production – not just OPEC, but the actual amount of oil available to the market worldwide – dropped by 5 billion barrels a day. That was 7% of total production … and the price went up fourfold.

Similar patterns are, predictably, shown during the Iranian revolution and the subsequent Iran/Iraq war of 1980.

So it’s obvious right? Big to-do in the Middle East = big supply shortage = price rise. Well, kind of. The problem is that the prices always rise ahead of the actual supply shortage. And how far prices spike is open to a lot of speculation. So as is often the case, guessing early and right is the key to making the real money (in retrospect, could you have predicted the acrophobic price drop that followed the Gipper’s removal of U.S. price controls in 1981?).

That’s all complicated by the long lead times and the conservative nature of the oil industry. Even today, with oil prices sky high and people talking about $100/barrel oil, oil majors are planning their production patterns based on an average price of $40/barrel. It takes a long time for the majors to adjust to higher prices and build capacity, so the long-term supply/demand ratio adjusts only slowly.

Let’s turn our attention to the present. Recently, Iran has been making noise and insisting it will maintain its nuclear program. The result? Oil prices are high.

Well, on the one hand it makes sense. Perhaps we’re going to go to war with Iran, and Iranian oil production will collapse (again). But then again, perhaps everyone will hold hands and sing Kumbaya and Iran will actually have a nuclear power system in place in a few years and all that extra oil will flood the market. It’s easy to see which way the market’s betting, but is the market right?

As things get stirred up, future prices rise, because it becomes more important to know your car will start tomorrow, and a premium is paid for that guarantee; remember, oil is a utility commodity. So when it comes to war - say, the one we’re in right now - it’s the threat of change, the disruption of the status quo, that moves the market, more than the everyday reality of war.

And this is just one of dozens of factors to consider. Not only do you need to worry about the big picture, you need to worry about the little ones. Unrest, elections and strikes in Nigeria, Cyclones (think June 7’s Gonu near Iran)?

And then there’s the perennial problem of market expectation. If you stick to U.S.-dominated markets, like T-Bills, you only have to worry about the Fed, and you know exactly when you need to worry about what; the Fed’s meeting calendar is conveniently published. All of Chairman Bernanke’s appearances before Congress are carried on C-SPAN. But when the Saudi oil minister comments on an otherwise random day in February that the oil market is “healthy,” and this is considered rational CNN-level explanation for a price drop, clearly you’ve encountered a Federal-Reserve-of-a-different-color.

Was the market “pricing in” an OPEC cut? Well, according to the press it was. But if the price of oil had rallied that day, what would the headline have been? Is the headline driving the price or is the price driving the headline? Or how about this: the International Energy Agency released its June report stating that demand for world oil is up 2% from its previous forecast. And prices fell by the end of the day. Is the market anticipating OPEC finally giving in to pleas to increase production, even though it states it won’t?

Like so many things in commodities, unless you know something we don’t, you’d best pay really, really close attention to the facts if you’re betting on oil. Pipelines, production and politics. Technology, innovation, espionage and exploration. Either be a student of them all, or listen to experts like Ken Medlock, or make long-, long-term bets that stick with passive strategies and historical returns.

Comments

[dcappe10:]

Great article, for anyone betting on oil or contemplating it, you must read this article i found too....It WILL open your eyes.

www.dailyreckoning.com...

Enjoy...Cheers!

2007 Jun 15 04:12 PM

[Jack s:]

The most illogical reason oil goes up is when refinery utilization goes down. That makes gasoline prices rise and oil follows. The truth is that if refineries are not producing gas, there is LESS demand for oil, yet oil goes up.

2007 Jun 16 11:27 AM

[LeeCarlson:]

Oil prices have become a "Game that countries and Corporations play". It is not a mattter of Supply and demand any more. It is a political football, and a Corporate profit game.
There is no shortage of oil, and there has never been a shortage of oil,..or gasoline.
Do you see any back-ups at the gas stations ?? Yet the prices go up and down like Yo yo's ! But always gradually higher. It won't end until there are real alternatives to oil or less demand for oil !! Like more insulated homes, like more fuel efficient cas, like we haven't built a Nuclear power plant in 30 years, like the people who have to have the biggest car or truck on the block because it shows the world that they have "many bucks". All factors in the game. Countries like France get about 80 pct. of their power from Nuclear power plants and drive small cars, but there is no incentive to build more here ??
Doesn't really make any sense, does it ?...Well, it does to the major oil companies !
Did everyone forget about the laws of supply and demand ? When demand goes down, Oil will be cheap again ! Until then,..it's just a game !! LC

2007 Jun 16 02:03 PM

[Mmarrkk:]

So, the big bad oil companies are to blame for there not being any more nuclear power plants and the lack of small cars on the roads in the US?? Is that really what you meant with this statement: "Countries like France get about 80 pct. of their power from Nuclear power plants and drive small cars, but there is no incentive to build more here ??
Doesn't really make any sense, does it ?...Well, it does to the major oil companies !"????

Please enlighten us all as to how oil companies are the ones fighting tooth and nail against nuke plants! Last time I checked it was a bunch on NIMBY's or long haired goof ball "progressives". And how are the oil companies forcing us to not buy small cars??? Every dealer I drive by has hundreds of small cars on their sales lots. And you know what? NO ONE IS BUYING THEM! So I guess the oil comp;anies have brainwashed everyone and told them they can't buy small cars!

You guys are a riot!

2007 Jun 16 03:51 PM

[Angry Physi...:]

Ronald Reagan abandoning price controls lead to a great drop in oil prices in early 1980's? Give me a break.

Maybe, in US, for natural gas---which is not a world fungible commodity---it's a potential hypothesis.

For oil, everybody is ignoring the obvious. In the early 1980's,
Significant oil was discovered and exploited in the North Sea at maximal commercial
production by Britain and Norway---capitalist and NATO allies. And Cantarell (the planet's second biggest oil field after Ghawar) came on line in a similar period, and the Alaskan oil was really flowing. (And there was a big recession, too). Those discoveries, plus the war in Afghanistan, helped to topple the USSR.

Guess what? North Sea oil production, and Cantarell is crashing. Not just a modest decline but a serious crash. Oil price is marching ever up, and Russia is rising once again, and in a triumphalist and sour mood.

All the high tech employed by Britain and Norway resulted in sucking out the oil faster, but it doesn't actually seem to get much
more total oil!

2007 Jun 16 08:58 PM

[Ronmac:]

I also enjoy the people who really believe the problem is the oil companies. Right....The problem is too much demand and not enough supply...wait till and China and rest of the world really get going and really try to be like us...We need to get off of oil...NOW...but, as usual, it will take a complete crisis to move us...Maybe this is the start...it better be, or be prepared for higher prices, resource wars, and all the other nastiness...

2007 Jun 16 09:16 PM

[LeeCarlson:]

Only one thing for sure,...The debate will continue...!
Oil companies have much to gain by higher prices, but there is no shortage, so they blame it on the shortage of refineries,..and lets not forget the guys who buy oil futures but never take delivery,..
and wind power is not the answer as you have to have at least a wind speed of 12 MPH continually to make them work, and most of the US doesn't have that kind of wind,..ethanol,...? ..It's only got 70 pct. the energy of gasoline and thats why some gas has to be added to ethanol, and yes,...someday we can make the ethanol more efficiently,...but then we would have to get the Gov. off our backs because of the big tax on "FUEL" and fuel is defined as anything you put in the tank !!!
The bottom line is that we have to use every method we can come up with to power cars, and power plants, etc. We can't anymore blame it on just a shortage of gas !! It has to be a combination of methods, even more effective insulation on homes and factories, shorter trips, and even perhaps shorter wars !
Ever stop to think how much fuel is used by an aircraft carrier to get planes to the mid-east and then to contimually refill the planes which go thru fuel like crazy !!! So guys,...there ain't just one simple solution, it's a combination of conservation, perhaps geothermal, insulation, smaller cars, nuclear power, etc. etc. but some people will continue to blame it all on one company or perhaps even one person,..who knows but as I said, the debate goes on !!! Have fun !

2007 Jun 17 01:54 AM