The Current Action in Crude Oil: An Enigma?

August 18,2014

 

Issues and violence are flaring across the Middle East, the traditional production base for crude oil that powers much of the globe. Tensions are running high between Russia and the West over meddling in Ukraine. Russia is a huge oil-producing and exporting nation. Common sense would dictate that the price of crude oil should have moved higher, but it has done exactly the opposite…

There are many reasons why crude oil has moved in a counter-intuitive fashion.

The nominal price of crude oil itself…  

Quarterly Nymex Crude

The nominal price of NYMEX WTI crude oil never traded above $41.15 per barrel until April 2004. Since then we have seen crude oil prices explode to a high of $147.27 in July 2008 and trade around the $100 per barrel level after a correction in late 2008. The higher price for oil launched exploration and production from areas not tapped in the past. The US and Canada have become huge oil producing nations with crude oil being recovered from the Permian Basin, Bakken region and from tar sands just to name a few. This new production, made possible by higher oil prices, has added to global reserves and has created some degree of independence from Middle Eastern crudes, which traditionally cost less to recover.

Global demand in light of a weak global economy…

The housing crisis of 2008, credit default debacle as well as a European debt crisis caused incredible market volatility over the past six years. Central bank policy of Quantitative Easing and low interest rates in the US and in Europe has kept interest rates at historically low levels. Recent economic numbers from Europe have shown little or no growth in Germany, France and Italy. Lower growth often portends lower demand for industrial commodities as recession saps spending from the economy. Lower growth in Europe, continuing economic concerns in the US and a slowdown in the largest commodity-consuming nation in the world, China, has translated into less demand for fuels such as crude oil and oil products.

Too many speculators got long as global tensions flared in June…

As Russia amassed troops on the border with Ukraine, ISIS rebels took over towns and cities in Iraq and reports of violence flared in the rest of the Middle East in June and July it was a natural response for traders and investors to buy crude oil. At first, prices lurched higher trading up from $100 per barrel on May 30 and peaking at $105.55 by June 23.  Then something happened.

Daily Nymex Crude

On July 1, open interest (the number of open long and short positions) in the NYMEX crude oil futures market peaked at 1.79 million contracts as traders and speculators went long and increased long positions based on geopolitical events. The price of crude oil did not cooperate with the longs and started to move lower. The lower the price moved, the more frustrated longs threw in the towel and closed their positions. Clearly illustrated by the 9.7% decline in open interest over a six-week period this summer, was the frustration of those who bought crude oil futures contracts. With the liquidation of each losing position, the price moved lower.

Should Brent have moved higher versus WTI?

Since the onset of the Arab Spring in 2011 the premium of Brent crude oil, the benchmark for Middle Eastern, African and European crudes moved to an all-time high premium over WTI to almost $30 per barrel.Weekly Brent vs WTI

Many traders and speculators purchased Brent crude rather than WTI NYMEX crude in June and July as Middle Eastern and Russian issues flared. In another counter-intuitive move, the premium for Brent over WTI slipped along with the price. Brent has recently traded at just above a $5 premium to WTI and is trading in a range between $5- $9, the lowest level in quite some time. Perhaps increased world oil production from new sources due to high nominal prices has muted the fear premium attributed to Brent over past years. Moreover, on a long-term historical basis, given the lower sulfur content of WTI making it easier to refine into gasoline, WTI has traditionally traded at a small premium to Brent.

The forward curve in crude oil could be telling us something…

At the same crude oil, prices have been coming lower, deferred crude oil prices on NYMEX crude oil futures have not been moving along with nearby prices. The backwardation (the deferred discount relative to nearby prices) in crude oil has narrowed dramatically over recent weeks. Nearby crude oil versus December 2017, price differentials have fallen from $20 in June to close on August 15 at only $8.30- a fall of almost 60% on the spread. This could indicate that consumers may be hedging forward crude oil consumption and that the fear of any short-term supply disruptions in the oil markets has dissipated due to all of the new sources of production.

The bottom line…

Conventional wisdom in the oil market was dead wrong this summer. All of the ingredients for a bull market were in place but the price went south. Fundamentals for crude oil have changed given new sources of production due to higher nominal prices. When fundamentals change, it can take the market months, sometimes years to sort through all of the potentials. Expect crude oil volatility to continue and continue to expect the unexpected!


 

 

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities.

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