Crude oil prices this morning are up slightly and effectively flat following the fast decline earlier this week.
Despite the clamor being raised by "analysts" portending a bloodbath in oil prices during the sharp decline late last week, neither the underlying market dynamics nor the oil trading contracts themselves were pointing in that direction.
You see, the drop in price actually had very little to do with the real supply of oil...
The Real Cause Behind This Week's Oil Decline
As a matter of fact, a good deal of what has transpired is once again an artificial swing to generate short-term profits for traders and bears little reality to what is really happening.
Before getting into the why, some figures are in order.
As of close yesterday, WTI (West Texas Intermediate, the benchmark crude rate used to set futures contract prices in New York) had declined 8.2% for the month, but had actually turned positive (a 0.5% rise) for the most recent week.
Meanwhile, Brent (i.e., Dated Brent, the London equivalent benchmark) declined 7.2% for the month through close yesterday and was up 0.8% for the week.
Yet here's the interesting matter transpiring in all of this. By standard metrics of supply and demand, the rise in U.S. excess supply - the culprit for a "massive collapse" in oil prices, as one of the talking heads on the tube put it this week - was hardly up to the task.
The extent of the pricing dive was not the result of rising U.S. production. Now it certainly was a contributing element for some of it. The American production totals had been rising for nine consecutive weeks, throughout the rollout of an OPEC-Russian accord to cut overall production that did not include any participation from U.S. providers.
For some, therefore, the United States was simply benefiting as a "free rider" to the Vienna Accord and its aftermath without having to pony up any cuts itself. And there is some truth in that opinion.
But the bottom line is this. The 8.2% decline in the WTI price this month was not simply a result of excess American production, despite what some pundits would have you believe. In fact, my preliminary calculations put the U.S. increasing production as the cause for no more than 4% of that decline.
An absolute majority is coming from someplace else entirely. Consider three primary factors.
First, the spread between WTI and Brent levels has increased to an average of 5.5%, or more than twice what it was prior to the pricing decline. Had it been an across-the-board decline, the spread would have declined proportionately.
Put simply, throughout this period, you would have made money by playing the paper barrel (futures contracts) against the wet barrel (actual oil in consignment for physical trade) in WTI against Brent. And that would have accentuated the overall weakness of WTI.
Second, U.S. producers are now exporting 1.2 million barrels of crude daily and already export more refined oil products than anybody else worldwide. This follows a congressional decision two years ago, the result of a "compromise" to avoid a budget default, to end a more than four-decade-old prohibition against exporting American crude.
Therefore, there is a more powerful way developing to play the WTI-Brent spread by expanding its applicability. Brent is used more often worldwide on any given day as the standard for discounted contracts than is WTI.
Both are sweeter (having less sulfur content) than more than 80% of the oil traded. That means the price of an average consignment in the international market is set at a discount to either Brent (the preferred benchmark) or WTI.
The present American exports are largely going into storage elsewhere (especially in Rotterdam, the largest crude oil storage location in Europe), rather than having formal contracted end users (such as foreign refineries).
However, both the refined oil products and the pass-through crude for export are moving through American refineries. It is in the interest of those refineries to magnify the pricing difference by cutting paper to depress the WTI price.
It is, therefore, of more than passing interest that the period producing an 8.2% decline in the WTI price for the month, and a 0.5% rise for the week, has resulted in the average values of publicly traded stock in the U.S. refinery sector improving 1.2% for the month and 3% for the week.
Third, what has emerged as a "manipulation for profit" has been further supported by the continuing improvement on the demand side both in the United States and globally. Artificially driving the price down cannot be sustained by relying upon the existence of rising supply if the demand for crude is moving down as well.
There is a simple reason for this.
In a non-volatile market environment, a trader will peg the price of a futures contract on the expected cost of the next available barrel. On the other hand, when the market pricing expectations are moving down, that dynamic becomes one of setting contract price on the expected lowest cost of the next available barrel.
That is where the accentuation of the decline takes place and the primary profit is made. Not from what the market is really giving, but from what can be manipulated in the short trade paper controlling the underlying oil.
Of course, once the run has been spent and the market starts rebounding, these shorts must be unwound with longer positions replacing them. Should events contribute to a perception of a supply shortage (or even a levelling off), the market can then experience a pricing rise moving beyond what the underlying factors would justify.
Like any roller coaster, what plummets down must move back up.
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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.