What Actually Drives The Price Of Oil

|
Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Elite Wealth Management

Summary

Supply is currently higher than demand by an estimated two million barrels per day according to the Energy Information Administration.

Cross-market context is equally key. Watch the futures curve and options market.

On April 17, 2016, key oil producing countries will be meeting in Qatar to “follow-up” on production freeze talks.

Click to enlarge

Commodities are often associated with purely speculative investments. This is simply not the case. Just like a stock, commodities have fundamental drivers too.

The price of oil has become increasingly more important since it began to tumble back in June of 2014. When the market started to trend with oil, interest in black gold surged even more. With renewed interest in oil, it's essential to look at what the professionals consider when analyzing a trade.

The oil market can be broken down into data points that derive from the price of oil, futures contracts, production, demand, and a variety of other factors. Looking into these factors will bring context to your oil investment.

The Fundamentals of Oil

Fundamental analysis normally starts with earnings or revenues. Traditional investable assets like real estate, bonds, and equities generate cash flow for investors-making valuation and fundamental work easier. Commodities like oil, on the other hand, don't have cash flow-making them a pure price play. Accordingly, it's essential to step back and observe the oil market from a macro point of view in order to grasp the current fundamental backdrop. This boils down to supply and demand dynamics.

According to data from the Energy Information Administration (EIA), there is a tremendous daily glut of oil hitting the market. As the chart below displays, there are two million barrels per day right now not being used. The oil market has only seen this level of imbalance a few times in the last two decades, but none have been this prolonged.

Weak demand and oversupply have driven the most recent downdraft in oil. As the chart displays, there has been a strong relationship between the supply/demand spread and the price of West Texas Intermediate (WTI) crude-also known as Texas light sweet (with light referring to the amount of light hydrocarbon fractions and sweet referring to sulfur content). Supply and demand figures are essential to the oil market, but where is all this extra oil going?

Click to enlarge

Storage-The EIA also disseminates the level of petroleum inventories in the U.S. on a weekly basis. This data gives investors additional context as to the state of the market and assists in price discovery. Crude oil inventories are hitting highs not seen since 1930-an extra 532.5 million of barrels are in storage, depicted in the chart below from Bloomberg.

With all this extra supply in mind, producers have cut back on production, jobs, and projects. The EIA recently estimated that producers have bailed on roughly $100B in investments, mainly due to weak prices and a poor macroeconomic environment.

For example, the Baker Hughes Rig Count has fallen more than 75% from its highs back in mid 2014. Rig counts are key for the exploration, production, and downstream services businesses that rely on their activity to survive. "Active rig count acts as a leading indicator of demand for products used in drilling, completing, producing, and processing hydrocarbons," according to Baker Hughes.

Neil Atkinson, head of the EIA's Oil Industry and Markets Division, recently suggested that the fundamental lack of investment in the oil industry could actually lead to a shock in price. "There's danger as we are reaching a point where we are barely investing upstream. If investment doesn't resume in 2017 and 2018, we can see a spike in oil prices as oil supply can't meet demand," said Atkinson at the Singapore International Energy Week conference. A bold, but possible, prediction given the mass exodus from the energy sector in such a short period of time.

Look at What the Pros are Doing

Very seldom do investors get to peek into the trading books of professional speculators. It is also very rare for pro traders to see the positions of competing firms.

The Securities and Exchange Commission (SEC) requires large hedge funds to report stock positions within 45 days of the end of a calendar quarter, but the Commodity Futures Trading Commission (CFTC) makes large commodities traders report positions once a week!

Savvy investors use this information to gauge the bias of commercial and non-commercial traders. According to the CFTC, traders are "commercial" if they use derivatives to hedge and "non-commercial" if they use the market to speculate or invest. A common "non-commercial" trader is further broken down into the sub-category of "managed money traders" (MMT). MMTs are commonly referred to as hedge funds in the media. Knowing the intention of these traders is essential when looking at the open interest data the CFTC publishes. For example, when looking for long-term trends, fast money type hedge fund traders might not be the best data to look at.

Open interest is the total volume of all futures and/or option contracts entered into but not yet offset by a closing transaction (delivery or trade). When positions are greater than pre-set reporting levels, that information is reported to the CFTC and published. These positions normally make up 70% to 90% of all open interest, so this is a great snapshot of how market participants are positioned. The data is then separated into commercial and non-commercial traders.

Traders and the CFTC alike track this very closely, but for very different reasons. Traders, as previously mentioned, like to see what other participants are doing on balance. In the most recent Commitments of Traders (COT) report, MMTs took in their bearish oil bets by 33% on the New York Mercantile Exchange (NYMEX)-helping push up oil prices 3.6% from the previous COT report. Shorts buying back futures assisted in driving the United States Oil Fund from $9.70 to $10.01.

Click to enlarge

What Traders Think the Future Will Hold

Derivatives traders are currently pricing oil to be in the low $40's for quite some time, as displayed by the futures curve below from TD Ameritrade. Between now and February 2017, current prices are suggesting oil will only be a few points higher.

Click to enlarge

This curve is in line with what Goldman Sachs believes will be a "transformational" year for the oil business. In their 2016 Oil Industry Outlook, the firm went on to say that the market would be "lower for longer". Goldman thinks the oil "supply chain is still highly deflationary and the full equilibrium price, over time, will keep shifting lower."

The one standard deviation confidence interval is rather wide, however, for oil due to elevated implied volatility in oil options. Specifically, the CBOE's Crude Oil Volatility Index (^OVX) is still up nearly 140% over the last two years. The one standard deviation range for light sweet crude oil is currently at +/- 16% for oil contracts expiring in just 84 days. The market is flashing signs of uncertainty, but the oil market is still in contango-an upward sloping futures price curve across expirations -- which could signal the risk is to the upside in price.

Conclusion

At the end of the day, markets are driven by supply and demand. While commodities don't produce cash flow, there is still a tremendous amount of supply and demand data to look into when considering an investment.

It is common for traders to review physical oil, drilling rig, and futures data, as these are the factors that drive decisions of industry experts. Interestingly enough, a number of industry titans will be meeting soon.

A key date investors should be aware of is April 17, 2016. The Organization of Petroleum Exporting Countries (OPEC) and non-OPEC countries will be meeting in Qatar that day to "follow-up" on production freeze talks from January 2016. The headlines that come out of this meeting will likely determine the next leg of oil's move.

Fariba Ronnasi
CEO, Elite Wealth Management

Disclaimer: This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

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.