Still on a Slippery Slope: One Chart and One Graph Tell the Oil Story by Dr. Van Tharp Trading Education Institute
The falling price of crude oil has been one of the biggest financial news stories of the last six months.
Of course oil prices have a big impact on producers and consumers but let's put some numbers to that proposition. In a Goldman Sachs report, David Kostin notes data from the U.S. Bureau of Economic Analysis that shows energy input costs make up more than 2% of U.S. private industry gross revenues. And in their February 2013 report, when gasoline was averaging $3.70, the Energy Information Administration showed that the average household spent $2,912 per year on gasoline, or a whopping 4% of pretax income.
So yeah, oil prices are big deal.
But instead of re-hashing tight-oil production increases in the U.S., Saudi Arabia's political and economic agendas or the reduced demand growth in Europe and China, let's look at two powerful graphics. These shine some really interesting light on oil pricing and its broad-reaching effects.
Saudi Arabia's Oil Agenda Is Working
Here, in one cool chart, we see what Saudi Arabia has been trying to do in keeping their production levels high, despite a global surplus. Take a look at this chart put together by Bloomberg's Grant Smith. It shows the relationship between West Texas Intermediate (NYSE:WTI), the U.S. oil grade traded in New York vs. Brent, the international standard that is traded in London:
In this graph, the orange and yellow lines (Brent and WTI price, respectively) have their y-axis scale on the left, and blue line or the amount WTI is trading below Brent is shown on the right-hand scale. As the two benchmark prices converge, the spread decreases (going up on the right hand axis). While $1.28 per barrel is a notable difference, it pales in comparison to the whopping $15.49 spread that existed just one year ago!
So what? Well, when U.S. shale oil was 15% cheaper than the price of Saudi oil, refiners in the U.S. had a strong monetary incentive to buy U.S. oil instead of imported offerings. Saudi Arabia has plainly stated they want to slow the growth of shale oil production in North America. With the spread tightening (now a difference of only about 2.8%), the price advantage for domestic shale oil has dropped significantly.
Bottom in Crude?
How low could oil go? The downside for crude oil prices has so many variables to factor:
• Will the oil producing regions remain free of significant conflicts for an extended period?
• Will global demand growth remain tepid or could major economies even contract?
• Will major producers finish capital projects to bring on significant new capacity (Iraq, Libya)?
• Will Iran succeed in normalizing international relations and add even more production capacity after sanctions are lifted?
• Whither goes shale?
With a foggy crystal ball, it's tough to balance all of those inputs. But absent a major conflict popping up in an oil producing region, most signs point to increased supply growth and neutral to reducing demand growth. That equals crude prices remaining at lower levels for longer than many have yet to realize.
On the technical side, the plunge in crude puts us at a very interesting, very long-term support level. Let's look at chart of spot crude prices in WTI dating back to 1983:
As you can see, we're at a very important technical juncture. If the price can't hold current levels (+/- a dollar or so), then we could soon be talking about oil prices down in the $30s.
At the moment, however, crude is so oversold and so beaten down that a bounce from here is the most likely scenario. But Saudi has the easiest spigot to turn up or down so they could choose to press their advantage for weeks or even months while relying on their huge cash reserves.
Because of the Saudi's market influence, if you are inclined to find a place to get long any form of a crude play, don't try to catch the falling knife. Wait for confirmation (even significant confirmation) before getting involved on the long side.
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