For the past week, I've been discussing some of the broader - and more technical - factors in the oil trade.
But my overall conclusion in each of those issues was this...
A rise in crude oil prices was coming, at least in the near term - a conclusion that has certainly come true.
As I'm writing this (Thursday, March 22), the West Texas Intermediate (WTI) price has surged almost 3% for the day and more than 5% since the close on Monday, and is up 6.5% in a week - its highest level since the beginning of February.
Meanwhile, Brent has registered equivalent gains of 2.9%, 4.6%, and 6.5%, respectively.
Now, there are two essential reasons why the price improvement is taking place, and both bode quite well for investment returns in the sector.
Oil's "Usual Suspects"
The first reason goes to the "usual" suspects:
- U.S. production levels
- Geopolitics
- Demand
- Currency exchange rates
These are familiar, traditional, and market-based considerations.
American extraction came in much lower than expected for the week. Estimates from the Energy Information Administration (EIA) showed a decline of 2.6 million barrels. However, analysts had expected a 2.5 million increase.
Now, a variance like this is hardly news.
In fact, the EIA and analyst expectations tend to move in different directions over 60% of the time.
Somewhat unusually this time around, however, was the convergence between the EIA and analysts on the two other major weekly figures - gasoline and distillates (diesel and low-sulfur heating oil).
Only crude oil showed a marked disparity.
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Now, geopolitics can once again be used to explain all manner of events in the energy sector.
This time, we can point to concerns over:
- Rising instability in the Persian Gulf as the Saudi Crown Prince visits D.C. as Trump considers ending the Iranian Nuclear Accord
- Washington considering sanctions against an imploding Venezuela
- The intensifying Libyan conflict
- Chinese saber-rattling in the South China Sea
- Ongoing Nigerian domestic problems
I often note that geopolitics are no longer an outlier when considering the energy markets.
Rather, the uncertainty resulting from cross-border and global unrest is an ongoing staple element.
Nonetheless, pundits often use it as a catchall for anything they have difficulty explaining.
Geopolitics may influence how one regards the potential future oil availability, but until the oil flow is actually impacted, its influence is more apparent than real.
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The Misunderstood "Yardstick"
Demand remains one of the most misunderstood yardsticks to measure oil.
Yes, the balance between supply and demand certainly does influence the oil price, but the real importance is the effect it has on the amount of excess supply.
Oil requires available volume beyond what the market needs at any time to narrow the pricing range. Of course, too much excess volume will prompt prices lower, while the opposite will drive prices higher.
When we speak of a "balance," it always assumes the availability of excess volume beyond immediate requirements.
That balance is rapidly emerging and, in some regions, may have already arrived.
Finally, currency exchange rates speak about the foreign exchange rate for the dollar. The vast majority of all international oil trade is denominated in dollars. When the value of the dollar declines against other currencies (especially the euro), the dollar value of a barrel of oil increases.
And recently, the weakening dollar has resulted in that upward pressure on crude.
The second major category considers the more detailed matters of oil trade we covered in the last two issues of Oil & Energy Investor...
Oil's Perceived Price
Remember, the one common thread permeating all of this is how the forward price of oil is perceived by the trader.
Here, as I have noted, traders will peg the oil price in a future contract to the expected cost of the next available barrel of crude.
Options - and more exotic derivatives - are then applied as insurance against movements in either direction.
Throughout all of this, the perceived direction of prices becomes the driving engine in traders' actions.
If that perceived trend is moving up, traders will compensate by setting future prices based on the expected most expensive next available barrel.
The opposite, as in the least expensive barrel, governs the mindset if the trend is moving lower.
Keeping this in mind, therefore, the most direct way of concluding which way it will move is rather straightforward.
It involves the number of short versus long contracts being exercised.
A short is run if the trader expects the price of any underlying commodity or equity is going to decline. Conversely, a long contract anticipates the underling will rise in price.
Until last week, shorts held considerable sway.
That changed abruptly on Thursday, with long contracts taking over.
The New "Head Honcho"
Longs are now driving the market.
Another result of this transition is the need for holders of shorts to liquidate positions, requiring that they go back into the market and purchase contracts.
That serves as another upward pressure on prices.
All of this evens out at some point into a new equilibrium.
After all, that is what trading markets always seek.
But the important point to remember is this:
It's not the ceiling, but rather the floor of the pricing range that actually determines the direction of movement.
Once the dust settles, if the floor is rising, so are the pricing expectations.
That is what we have at the moment. And that's all we need to make money with targeted moves.
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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.