Earlier this spring, I talked about the importance of a stable oil pricing "floor," saying it was even more important than any gains crude might make in the meantime.
That's because establishing a floor, a price oil won't dip below, is what actually generates profit opportunities – for everyone from Exxon Mobil and Shell to investors like you.
Now, OPEC’s failure yesterday in Vienna to reach an output deal sent oil sliding again, despite around three weeks of solid gains. But later in the day, news that U.S. crude stockpiles dipped below 1.4 million barrels sent prices back up into the green for the day.
So oil is essentially treading water now. Naturally, the airwaves filled with fretting pundits, all mourning crude’s inability to stay above $50, an arbitrary “ceiling” predicated more on psychology (and undeclared short positions) than any market reality.
So, let them cry into their studio mics. We're much better off ignoring them – they're looking literally in the wrong direction.
Here's why oil's price floor will make you far more profits than any ceiling ever will…
Oil Can't Stay Above $50, but That's Not Important Now
Crude oil prices are essentially settled in the range that I've been predicting for some time: West Texas Intermediate (WTI), the benchmark rate for futures contracts in New York, having a ceiling price of $48 to $50 per barrel by mid-June.
As of close yesterday, WTI was above $49, while dated Brent (the other primary benchmark, set in London) was $50. Furthermore, the spread between the two – calculated as the difference between the two viewed as a percentage of WTI – has now dipped below 1.5% several times, pointing toward the price once again approximating an actual market indicator.
WTI has now risen 83.7% and Brent 58.4% from their respective lows this year, both less than four months ago on Feb. 11. Now, as I've been predicting in several of my research services this week, oil's recent rise is over. In a moment, I'll show you why that's nothing to worry about.
External factors have certainly contributed to the recent spike: Wildfires ravaging Fort McMurray, Alberta, in Canada's most productive oil country have only come under control in the past week, and insurgents are intensifying their attacks on oil installations in Nigeria's Delta States. Both of these disruptive events have offset recent improvements in Libya's ongoing civil war, the third external geopolitical factor.
Pundits (perhaps trying to prompt a decline in oil prices for their own ends) are quick to point out that these factors are…
(1) hardly permanent, and;
(2) have no impact on the continuing oversupply weighing down upon the market.
Now, all of that is true… But it's not remotely as important as the chronic oil bears are letting on.
Oil Reserves, Not Oil Supply, Make the Ceiling
It's true that none of these crises – the wildfire, the insurgency, the civil war – will last forever.
On the other hand, geopolitics and Mother Nature remain integral elements affecting oil – several other natural or man-made crises could pop into existence at any time, in any number of locations, whether oil is extracted there or not.
And as for these disruptions having no impact on the oversupply of oil, it's certainly true that excess oil volume continues in the market.
Yet, as I've said before, the culprit here is excess extractable reserves.
Traders routinely reckon with the fact that considerable additional supply could at any moment be dumped on the market from the known, easily extractable in situ reserves. It's this reckoning, rather than the actual black stuff sitting in storage containers across the world, that serves to temper how high oil prices climb.
However, global demand is once again on its way up. Despite excess production and new expanding sources (Iran's attempt to return to pre-sanctions oil production and export is a prime case in point), a balance is forming even in the presence of excess supply.
And remember, the market requires excess supply to provide liquidity in commodity trades. Therefore, oversupply is not automatically a bad thing. In addition, we had significant excess supply in storage or stuck in transport bottlenecks throughout the period of $100-plus crude oil that ended in 2014.
So something else is at work.
And it's here that the main importance of the pricing floor emerges…
Oil's Price Floor Opens Up a Window to Market Profits
I've noted before that a stable range for oil trading results provides the best environment for both investor returns and futures contract prices, which reflect the real market conditions of "wet barrels," or the physical oil actually traded and delivered.
This happens when a floor – not a ceiling – forms in oil prices and begins to dictate trade.
But, among much of the cable news commentariat, floors are usually considered only if the lows are approaching some significant moving average. For instance, you've probably heard something like, "If the price breaks through X, then the next resistance is at Y," countless times.
But that's only part of the picture. The importance of a stable pricing floor extends to what that floor means to traders – how they set their contract prices and insurance (options).
In a stable market, traders peg prices to the cost of the expected next available barrel. That then requires less arbitrage between "paper barrels," or futures contracts, at expiration and wet barrels, which are of course actual consignments of crude.
However, perceived pricing volatility, in either direction, forces traders to change their approach. In the declining market we experienced over the past 14 months, traders need to hedge their contract risk by setting prices to the cost of the least expensive next available barrel.
Conversely, in a rapidly rising market, traders have to hedge by pegging prices to the most expensive next available barrel – or risk getting paid less than their competitors.
In either case, the rational actions of traders actually intensifies the up or down movement, far beyond what the dynamics of the market would dictate. Such excess contributions are also reflected in the greater use of exotic (and synthetic) derivatives by those who write futures contracts.
Meanwhile, traders use options to further limit their risk with either wet or paper barrels, again widening the impact of the trading perceptions.
In such cases, the actual price of the underlying commodity is distorted, much as it has been for the past year or more.
So the most important result of a stable pricing floor is reduced distortion, such as we're seeing now. And while the floor hardly stops pricing swings, it does limit the impact by changing how traders view their forward exposure.
And that in itself is enough to open up the market – for oil companies that can finally get a predictable and reasonable price for their product, and for investors like you, who can invest and ride the rising fortunes of those companies for profit.
So, if you've been sitting on the sidelines of the energy market – particularly the oil patch – now is the perfect time to jump back in.
More from Kent: This Trade Could Pay Off a Third Time… At this moment, a certain severe supply gap is threatening to create a worldwide crisis. This is an extremely rare event that has only happened twice before in market history. Both times, it sent a handful of stocks soaring tenfold. That’s good enough to turn $1,000 into $1 million. This same situation is happening right now for the third time, and, while nothing in the market is guaranteed, the potential is undeniable. Already, savvy insiders are loading up. Don’t miss this.
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.