The Two Real Reasons Oil Prices Are Currently Slipping

The U.S. Energy Information Administration just released its latest report on oil. And although I'm no conspiracy theorist, what's going on with oil prices has all the earmarks of a setup.

Each week, the report tells us what the crude oil and oil product markets looked like as of the previous Friday. It is usually the yardstick by which analysts appraise everything from oil supply through refinery utilization to the markets for processed products such as gasoline, diesel fuel, and low sulfur content heating oil.

This week's report showed criteria that would normally signal upward pressure on prices: a drawdown in oil supply, tighter refinery usage, and a widening spread between crude oil and oil product prices.

Now, this last criterion may be the most important for assessing pricing across the board. It involves the relationship between crude raw material pricing and supply on the one hand and similar considerations for gasoline and heating oil on the other (heating oil serves as a surrogate for diesel in these calculations since both distillates come from the same refinery cut).

Simply put, prices should not decline when the spread is rising.

So why are oil prices heading downward?

Distortion currently occurring in the market.

Here are the culprits behind this price manipulation... as well as how we can profit from these artificial moves...

A Drawdown Should Push Oil Prices Up

oil drillIn the past few weeks, the drawdown on supply has been greater than anticipated, in some cases by a significant margin. That spread is improving, which usually contributes to an overall rise in price for the underlying raw material.

Yet the pundits continue to grasp at straws in their attempt to explain the resistance to a rise in crude oil and oil product prices.

This time around the "spin" involves claiming a decline in gasoline demand has offset the upward pressure of an expanding drawdown on the storage side. For the past two weeks this has been shaping up as a pronounced cycle.

For one thing, the overall drawdown has been multiples of what the American Petroleum Institute had recently forecast. This week, it was no less than six times the industry estimate.

For another, the drawdown at Cushing, Okla., is even more important than the figure as a whole. Cushing is where the West Texas Intermediate (WTI) daily pricing peg is set for crude futures contracts trading in New York using the WTI benchmark. Consecutive weeks of reductions there have had a direct impact on the spread.

Not only are the concerns about gasoline demand missing the point, but they are themselves quite misleading when taken alone. Gasoline demand usually decreases this time of year, since refineries are already well into the cycle of switching from primary output in high-octane gasoline to heating fuel. A deeper warm trend in the fall, for example, almost always results in a spike in gas prices as usage extends longer than expected into what is supposed to be the cooler season.

Also, we have just experienced a tick up in gasoline usage in August and through Labor Day beyond what had been expected. This is at best a non-issue for this time of year.

So what gives?

Here's Why Oil Prices Are Depressed...

There are two matters of import at play here, both reflecting indirect paper moves having little to do with the actual underlying dynamics of the market:

  1. Another round of shorts by those who know no other way to make money from commodities; and
  2. A widening usage of derivatives based on what are called "crack spreads."

Regarding the first, the recent OPEC "opinion" that we will not see $100 a barrel of oil until about 2040 has to be read with more than a grain of salt.

As we have revealed in Oil & Energy Investor, major OPEC sovereign wealth funds have been shorting oil. It remains in their best interest to keep prices low to defend market share. In pursuing this objective, they are shorting their own product. Therefore, statements about reduced prices in the future merely support another objective entirely - one that has little to do with improving their revenue for the sales of oil!

As to the second, derivatives, some explanation is necessary. Crack spreads allow an investor to play the difference between both WTI and Brent (the London-set benchmark) and the market price of gasoline and heating fuel. Of course, the investments here are very big. This is not an approach any retail investor could make. But it is a recourse of hedge funds and their ilk that are intent on turbocharging short plays.

The combination of the two strategies are producing the latest myopic way to generate profits... as long as its adherents can persuade investors that depressed prices are ongoing.

Now to be realistic, we have a number of factors contributing to that persuasion - from an Iranian accord, through OPEC increased production, to a constriction in the U.S. shale-tight oil patch.

And then there is the other culprit: Goldman Sachs. The investment firm is continually talking down the price of oil and now suggests that $20 a barrel is possible. This analysis is far from objective, given that Goldman is the largest shorter of oil in the market.

A decline that profits the short crack-spread players becomes an easier sale.

...And How We Can Profit

Given these dynamics that are distorting the market, we are likely to approach $70 a barrel only next year, with a further move to $80 sometime beyond that (a view, by the way, on which OPEC concurs). Even without the shorts and crack-spread derivatives, we would still be coming in much lower than the triple digits of some 15 months ago.

But it is incorrect to assume that these machinations are merely reflecting, rather than dictating, what the market is telling us. There are plenty of other participants ready to continue external ways of distorting pricing.

By how much?

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I have been beta testing an index of wet barrel (actual oil consignments) comparisons to paper barrels (futures contracts and derivatives) in an attempt to find out. Initial reads are telegraphing a widening effective impact. As of the end of August and the first full month of running the yardstick, it was coming in at $8 a barrel in New York and closer to $9 in London.

By the close of trade last Friday (Sept. 18), it has both accelerated and converged, coming in at about $12 for both benchmarks.

Now, even pegging the actual price at $57, rather than $45, in New York still indicates a weak oil market. Nonetheless, as I fine-tune this tool, it will be telling us something else of greater importance to our purposes.

This approach should tell us when the curve is moving up before it appears in the market. And that will prove very useful in picking stock moves moving forward.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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