The Trajectory is for Oil Prices to Rise

Crude oil and gasoline futures contract prices moved down yesterday, as the market took a breather from an accelerated upturn.

But the overall medium-term trajectory for oil prices no longer appears to be in doubt.

As I have indicated on several occasions recently, the downward movement in May and June was an overreaction to softness in the sector, with the ultimate slide over twice as large as any objective reading of the fundamentals would justify.

We are now witnessing a return to a "normal" oil market. That doesn't mean a lack of volatility or a narrow range of trading.

This normal is hardly boring.

These Three Factors Determine Oil Prices

What it does mean is that oil prices will be determined by three factors:

  1. Supply and demand;
  2. The spread between benchmark crude grades; and
  3. Geopolitical tensions and events. Here, we are considering matters we've discussed here a number of times.

Now we will continue to see, on occasion, external factors weighing in, such as the concerns about the European debt crisis that pushed the markets lower yesterday.

That results in something I have discussed previously - a sort of "cart leading the horse."

It produces an expectation that, if the trend continues, it will depress overall demand and thereby push prices downward. Some of this occurs all the time; it is what fuels the usual movement of oil levels.

But it does not affect actual demand levels unless the situation is protracted. That is because such concerns are not part of the oil cycle itself. For them to become so, we need at least a quarter of movement in the same direction, and we haven't had anything close to that.

The move down over the six-week period in May and June has already been countered by a strong move upward over the past several weeks - overreaction countered by recovery.

The three factors that have a genuine consequence, however, are directing us back up.

On the supply side, we have witnessed a significant drawdown in inventories. This has been happening for several weeks now, but has had an impact only recently. That has been augmented by refinery capacity problems and interruptions of production from the North Sea (where pending labor actions are still a factor). Demand is returning in the U.S. market at levels even the pessimists are finding hard to ignore. Globally, however, the real drivers on the demand side have been moving up for some time.

Remember, this market is not determined by North American consumers or those in Western Europe, but by the developing world and emerging markets. There, oil demand is increasing and at a faster pace than anticipated.

This is not simply an estimation of energy demands in China and India. The developing world's dictation of demand levels is now much broader than those two economies. Given the integrated nature of the oil sector, what occurs anywhere has an impact everywhere.

The Brent-WTI Spread Widens

As to the second factor, the spread between the Brent benchmark in London and West Texas Intermediate (WTI) in New York is increasing (again).

At the open yesterday, the difference in price between the two as a percentage of the WTI price (the better way of looking at this) was in excess of 18% and rising.

That of itself tends to increase overall U.S oil prices. But it also does something else.

More than 85% of oil trades actually done worldwide each day are in consignments that have higher sulfur content than either Brent or WTI. That means these trades are discounted to the dominant two benchmarks.

Brent is used as the preferred base for pricing those trades and is used much more often globally than is WTI. And that translates into overall prices rising internationally faster when the spread is increasing than when it is contracting.

Iran Remains a Key Factor for Oil Prices

Finally, the geopolitical is becoming a major factor in the move up. Mideast tension is certainly in the forefront here. But it is the rising Iranian crisis that is the primary concern. Absent a resolution - and, for the reasons I have previously talked about in OEI, that shows no prospect of happening - this will get worse as we move into the third quarter.

This is because the European Union embargo of Iranian crude deliveries took effect only on July 1. The impact of that move affected only shipments changed after that date. We are now working through the first ripples of that effect.

And it will become worse.

That is even without trying to figure in what an increasingly desperate Tehran may end up doing.

Already over the past week, the head of the Iranian military confirmed they were setting up contingency plans to block the Strait of Hormuz (an action the U.S. Fifth fleet will actively resist), and the director of Iranian ports pledged insurance coverage for tankers moving Iranian crude.

This latter development results from both EU and U.S. sanctions now extending to shipping companies, insurers, and banks providing finance for Iranian oil trade.

Nobody in the business, by the way, has any idea where Iran will find the money for this underwriting program or how the country will be able to guarantee it - since the sanctions also cut the nation off from access to international banking.

These are the real factors behind how the oil market operates these days. These are hardly calm waters, and movement is not always in one direction. But the trajectory is for prices to rise.

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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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