Oil Prices Still Have Plenty Of Upside Potential

by: Daniel Jones


In a previous piece, I suggested that the futures curve for crude indicated that oil prices had more potential to the upside, something that has since been demonstrated.

After seeing prices move higher, I decided to dig into the data once again and concluded that this disparity has recently increased, implying more upside potential ahead.

Although this is not a guarantee that prices will go up, it appears as though higher prices are the path of least resistance according to Mr. Market.

Just the other day, I published a piece regarding oil futures and highlighted that, according to the data I presented, there seems to be an expectation by Mr. Market that oil prices (WTI prices at least) will rise over the next year. Although the futures curve is not a guarantee of what will happen, it does help to indicate the general mood of markets. Since writing that piece, the price of oil has gyrated and prices ended up soaring 12.3% on February 12th amid chatter of potential action by OPEC. Despite this rise after a previous crash, both of which happened after I wrote my article, the spread between current prices and futures prices has risen, suggesting that the rebound may not be over just yet.

A look back at my original analysis

In my last piece, I showed that the spread between current oil prices and futures prices a year out (March contracts for 2016 and 2017, respectively) came out to $10.80 per barrel. On a gross basis, this implies that investors could be guaranteed a return of 37.9% over the course of a year if they bought and stored barrels of oil in their basement and entered into the appropriate futures contracts. However, the gross basis does not factor in storage costs, which many analysts have estimated to range between $6 and $8 per barrel each year (including insurance, transportation, etc... as well). To account for this, I decided to assume a mid-point cost of $7 per barrel, which would yield a pre-tax return of $3.80 per barrel for a gain of 13.4%.

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Using these core assumptions, I concluded that investors in this space could receive a gain of as high as 42.8% over the course of a year if they can take this approach but borrow 80% (at an annual rate of 6%) of the capital needed to make this venture work. However, I also cautioned that this approach isn't really for the everyday investor because there are a number of risks involved and that it is intended, instead, for hedge funds, companies, and individuals who are extremely wealthy. Rather, the opportunity for more typical investors can be found in the companies that operate in this space and/or in oil ETFs. The underlying rationale is that, since this large degree of contango exists, there's likely to be upward pressure on crude, geared toward closing the gap.

That gap has now widened

After seeing oil prices fall after I wrote my last piece, they ended up surging higher on February 12th to close at $29.02 per barrel, about 2% higher than the $28.46 per barrel I based my analysis on. It may be tempting to think that this gyration in crude prices closed the gap for investors, but this doesn't appear to be the case. In fact, data shows that the trend has widened, likely a sign that oil prices could still move higher in the days, weeks, or months ahead.

In the graph below, you can see what the futures curve looks like for crude between March of this year and March of 2017 on a monthly basis. Between now and then, the curve takes us from $29.02 per barrel to $40.27 per barrel. This doesn't mean that oil prices will actually rise by that much (though they could). Instead, it suggests that the spread here, $11.25 per barrel, is likely to close to something in the range of current storage costs (per above, I'm still using $7 per barrel per year). This comes out to $4.25 per barrel being left.

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From today's price for crude, this implies a gain of 14.6%. In the table below, you can see the trend, on a monthly basis, that the curve takes on both a dollar and percentage basis. By applying the same strategy whereby professionals might buy oil using mostly debt, the annual return could be as high as 49.2%. The fact that such a hefty disparity still exists after seeing oil prices move higher implies that Mr. Market is forecasting something that is likely to help correct said disparity. Whether this means that it is expecting OPEC to cut, production to drop, demand to rise, or something else entirely has yet to be seen but the fact remains that this spread is bullish in nature.

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Unfortunately, nobody can accurately predict the future price of oil and anybody who says they can is a fool. However, we can take away clues from what the market believes is probable in the months to come by looking at the futures curve. This, in turn, allows us to make educated decisions that help to tip things in our favor and, right now, the direction that seems to be favored to some extent is long, not short. This doesn't mean that we will see oil prices suddenly spike higher but it does suggest that a volatile road will help to correct current prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.