In response to the rapid decline in the price of oil there has been a wealth of in-depth analysis and opinion covering all aspects of the oil business, global supply and demand issues and the geopolitical ramifications, as well as the message this decline is sending about economic strength in different regions around the world. What has been absent from this ongoing discussion, yet should be of primary importance, is what determines the price of oil.
What Determines Price?
The price of oil quoted each day is not determined by the large commercial enterprises that buy and sell the physical commodity. Real world supply and demand is largely irrelevant in determining price over the short-to-intermediate term. If it were a significant factor then we would not see price swings of 40% over a period of just weeks when real world supply and demand is varying by just 1-2% per annum.
The daily price of oil is determined on the futures exchanges by speculators and institutional investors. A futures contract represents the market price of a physical commodity at some point in the future. Traditionally, futures market participants were either the producers or users of the physical commodity, or speculators who provided the market with liquidity by selling when prices were too high and buying when prices were too low. Traditional speculators are limited in the size of the positions they can hold in order to limit their influence over spot prices.
Shortly after the tech bubble burst in 2000, institutions began to allocate billions of dollars into commodities through the futures markets in an effort to capitalize on growth in the developing world. Commodities became a new financial asset class. The continual and escalating flow of funds into a buy-and-hold strategy of a basket of commodities with no sensitivity to price led to a parabolic move upwards in prices prior to the financial crisis in 2008.
The regulatory body for the futures exchanges (CFTC) exacerbated the volatility by exempting Wall Street banks from the limits under which traditional speculators operate. As a result, a hedge fund can use a Wall Street bank as a counter-party to speculate on commodity prices for financial gain with no limitations. It is important to recognize that the vast majority of oil futures contract holders never take delivery of a single barrel of oil-they simply roll over the contracts. As a result of these changes in market structure, futures prices now dictate spot prices.
There was no greater evidence of commodity prices divorcing from fundamentals than the surge in oil to $147/barrel during the summer of 2008. That parabolic move occurred six months into what we now call the Great Recession. There were no lines at the gas pump. There was no outcry from oil-importing nations that they were unable to obtain the oil that they needed. That move was fueled by speculative investment flows into oil futures contracts in a herd mentality. The herd was being steered (over a cliff) in part by deluded research reports from Morgan Stanley and Goldman Sachs that were forecasting prices of $150 and $200/barrel, respectfully. Just a few months later the price had collapsed to less than $60/barrel, but not because of a commensurate decline in demand or increase in supply. Institutional investors and speculators were being forced to deleverage and unwind long positions in the throes of the financial crisis and stock market meltdown.
Wall Street analyzes the supply and demand relationship for oil as a physical commodity in much the same way that it analyzes the fundamentals of a publicly traded company. Investors and speculators trade the commodity on the futures exchange, which ultimately determines the spot price, in the same manner that they trade a public company's stock on the stock exchanges. In this respect, oil trades very much like a common stock. Regardless of what the actual supply/demand relationship is for oil as a physical commodity in the real world, it is investors' perception of that reality as either bullish or bearish that determines price.
Based on what I hear and read from Wall Street and our incurious main-stream media, the abrupt collapse in the price of oil is due to what seems to be a rather sudden oversupply problem in combination with a waning rate of demand growth-fundamental factors. It makes absolutely no sense to me that there can be anything sudden or surprising with respect to the most important, closely watched and relentlessly analyzed commodity in the world.
In actions reminiscent of the oil price surge during the summer of 2008, Goldman Sachs and Morgan Stanley have fueled the flames, but this time in the opposite direction. In late October, following what had already been a 25% decline in price, Goldman Sachs forecast that WTI crude would fall to $75 in the near term due to continuing oversupply and waning demand. Just five weeks later oil prices touched five-year lows following Morgan Stanley's forecast that Brent crude oil could fall as low at $43/barrel in the first half of 2015.
The decline in price has been spun as a positive for the US economy, despite the fact that we are now a leading oil-producing nation. Wall Street tells us that this oil price drop is a windfall for the American consumer. It is QE (quantitative easing) for the 90% of Americans that saw no benefit from the Fed's wealth creation policy over the past five years. The typical household will save $40-60/month (provided prices remain depressed at current levels), which it will then spend on other goods and services. The decline in gas prices will also encourage people to drive more, further stimulating economic growth.
There is no argument that lower gasoline prices act like a tax cut for consumers, but the assumption that the money not spent on gasoline by middle-class families is calculated, saved and then spent at Costco (NASDAQ:COST) and Wal-Mart (NYSE:WMT), is delusional. This is just an excuse for Wall Street to pound the table on retail stocks. What it does do is ease the burden on the majority of middle-class families that have no discretionary income. It is just as delusional to think that people will drive more just because gas is cheaper. Who plans a road trip that they would not have planned otherwise due primarily to the fact that gas prices have fallen?
Fed chief Janet Yellen said this week that, "From the standpoint of the U.S. and U.S. outlook, the decline we've seen in oil prices is likely to be, on net, a positive." This statement is as inaccurate as every one of the Fed's economic forecasts dating back to the financial crisis. What is absolutely staggering about this statement, if she believes it to be true, is that it reveals that she has NO understanding of what has been the driving force behind US economic growth and job creation in recent years. The energy industry currently accounts for approximately one third of overall capital expenditures, and planned expenditures are now being cut in response to the plunge in oil prices. The energy industry has also led all sectors in terms of employment growth since the financial crisis, and now energy companies are announcing layoffs in the thousands in response to the plunge in oil prices.
I believe that the collapse in crude oil prices to a recent low of approximately $53/barrel (WTI) is just as absurd as the surge in price to $147/barrel was during the summer of 2008. This price decline has far less to do with imbalances in real-world supply and demand, and far more to do with deleveraging, forced liquidations and repositioning in the oil futures market.
We know that energy companies have borrowed more than $500 billion over the past five years at unsustainably low yields. Much of this debt is below investment grade. The Fed's zero-interest-rate policy has encouraged investors to search for yield in the junk bond market that would not have otherwise done so. It has also encouraged institutional investors (hedge funds) to speculate using excessive amounts of leverage. While it is impossible to identify the trigger, it is my view that as oil prices edged lower during the late summer and early fall months, due in part to investors' response to increased rates of oil production, bond prices in the energy sector began to decline as yields rose. At some point the price declines hit technical levels that triggered more aggressive selling in the sector, which begot more deleveraging and liquidation.
There is an undeniable interconnectedness between the debt, equity and derivatives thereof in each sector. When bond prices started to decline, equity investors took notice and there was a ripple effect in the stock prices of the underlying companies. The stock price declines spread from the low quality small-cap names to their higher quality large-cap brethren. As energy stocks prices fell, speculators sold oil futures contracts. Wall Street analysts were called to arms by the price declines and immediately began to question industry fundamentals, and the ripple effect continues. The mainstream media is always the last to pounce, alerting the public to the fact that something it doesn't fully understand (and has no intention of taking the time to investigate) is currently underway. This creates a heightened level of anxiety, which is intended, leading less sophisticated investors to liquidate their holdings in the sector just as Wall Street starts to rebuild its own.
David Bianco, the chief U.S. equity strategist at Deutsche Bank, recently said that the "energy sector is a falling knife and should be avoided." He called the sector "uninvestable." I couldn't disagree more. The collapse in oil prices has presented one of the best long-term investment opportunities in a sector since the financial crisis in 2008. While Wall Street firms like Jefferies Group cut their price targets and reduced their ratings on companies like Schulmberger (NYSE:SLB) from buy to hold, long-term investors should be moving in the opposite direction. This is the time to be building a shopping list of the highest quality and most liquid names.
I would not be surprised to see a V-shaped bottom in oil prices similar to the ones we saw in the S&P 500 (NYSEARCA:SPY) during the months of October and December. Algorythmic trading programs (HFT) are the dominant force in our markets today and they dictate prices, in my opinion. They are also active in futures markets. When they withdraw liquidity, which they seemingly do every couple of months, prices collapse. When they reengage, prices surge almost faster than they plunged. That is not the way that markets used to operate. Recoveries used to take much longer than price declines in securities markets, because the majority of investment decisions were made by human beings. Those days are over. Now we see periods of no volatility followed by periods of extreme volatility. As a result, the S&P 500 can decline more than a 100 points (5%) during seven trading sessions, and then recoup the entire decline in the three that follow, as we just witnessed over the past two weeks.
The correction in October was reasoned to be the result of slowing global economic growth and an Ebola epidemic that was spreading across the globe. Within a couple of weeks the global economy was evidently not slowing anymore. Ebola vanished from the mainstream media headlines as though we had found a cure. I suspect that when oil prices make a rapid recovery back towards $75/barrel the issue of oversupply and slowing demand will have remedied itself.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.