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What Is Really Going On With The Price Of Crude Oil? at Trader’s Narrative





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Yesterday Bill asked me to take a look at the crude oil market. So here is a quick overview of what I think is going on.

Here is a long term chart of the price of crude oil along with its distance from the 200 day moving average:

crude oil distance from 200 day moving average

OPEC Tax
The price of oil, above a certain point, becomes a tax on western economies. The higher it goes, the less will be consumed and the less economic growth we’ll have. One of the reasons we had an amazingly powerful economy between 1998-2000 was that oil fell to single digits. So there is a built in mechanism in place to moderate price but due to structural reasons it doesn’t work with instantaneous or perfect regularity.

Indexing Fever
The recent parabolic rise may be explained by something other than a supply demand imbalance. In the past few years we’ve seen a trend towards commodity index funds which creates a positive feedback loop. The better the performance of commodity markets, the more funds are allocated to it by pension funds, hedge funds, and other institutions.

And we’re talking about billions and billions of money. And it is flowing to long only strategies. Just buy, and buy some more! It is somewhat similar to the hyper indexing phenomena we saw happening in the tech bubble years. As the Nasdaq 100 index went sky high, it attracted a lot of hot money who would buy ETFs or index mutual funds to chase performance. This would then propel the index higher as these funds would create new baskets to put this money to work in the market. So a positive feedback loop legitimized itself through self-created performance:

commodity managed futures assets chart
Source: It Takes Crude To Contango by Howard Simons at thestreet.com

The problem with a scenario like this is that it becomes increasingly difficult to call an exhaustion point. You can easily be steamrolled flat by the tremendously robust trend. Believe me, many very smart and well capitalized traders were flattened trying to short the internet bubble stocks. The trend will last until it doesn’t. That’s about as lucid an explanation as you can get.

Contango
The normal situation when the price of oil is rising is for future prices to be lower than spot prices. This is called backwardation. But right now the oil market is in contango - where future prices are higher. This is a rare occurrence which creates incentives for speculators to purchase oil, take it off the market, store it and then sell it at some point in the future to gain arbitrage profits.

So now we have speculators who are piggybacking on the commodity indexing trend, pushing it even further, as well as buying contracts in an attempt to “front run” the inevitable buy orders coming down the pipeline.

Flying Turkeys
All of this is happening in the derivatives markets and it is rather complicated for most people to wrap their minds around. Here’s a simple sign of froth in the oil market which most people can identify much easier. We are seeing small, extremely speculative stocks in the energy sector fly off into the stratosphere. For a quick example, take a look at the charts for Pyramid Oil Corp. (PDO) and MEXCO Energy Corp. (MXC).

Most of the stock spam is now pumping oil, gas and energy related over the counter penny stocks. This is the last stage of a parabolic blow-off. When the lamest and sickest of turkeys start to fly as if they were hawks. But good luck in actually pin pointing the top.

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19 Responses to “What Is Really Going On With The Price Of Crude Oil?”  

  1. 1 Warren Peary

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    I used to trade futures and a premium on the back months is usually more common due to the carrying cost that would be paid if the cash commodity was delivered and held. Perhaps the premium on the back months is larger than normal due to a perceived supply shortage in the future. Is this the case? This blowoff suckerpunched me. I had noticed starting earlier this year that the energy stocks were bearishly diverging from the price of crude and thought that meant crude was going to top around 100. It just shows that bubbles and blowoffs are impossible to predict. Thanks for your great commentaries!
    Warren Peary

  2. 2 chavez

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    Crude going to $200 next week. If gold can trade at 900 why cannot the ‘black gold’? Soon crude oil will be $1000 a barrel.

    - Chavez

  3. 3 Bill K

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    Babak, Thanks for your comments on oil. It sounds like we share the same opinion that it is a bubble, but not sure when it will pop. I am getting close to taking a stab at it. Right now I think too many people are trying to short it. When we take them out with a huge blow out short covering rally or two I think it might be time.

  4. 4 hammster

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    Is oil approaching a bubble? Nobody knows. Let’s simplify everything. The supply of oil is decreasing and demand is increasing, albeit maybe not from the U.S.

    As oil approaches $200 and oil companies trip over themselves to increase production, there may well be a glut of oil on the market in 2013, although refining capacity will be insufficient to process it.

    Between now and 2013, the only thing that will prevent high oil prices from going too high (whatever that is) is, coincidentally, the high price of oil. Consumers will change their car buying habits, limit the amount of long driving vacations, but that doesn’t stop the demand from China to fill it’s strategic reserves, and the thirst China and India will have on future consumption.

    Simply put, “cheap oil” is a thing of the past and we may well reach $200/barrel and $6/gallon in the next year or two.

    People think $135 may be a bubble but take it from somebody that does NOT know, you aint seen anything yet. Be smart. Invest long in oil drillers, help support future drilling efforts and think longer term, past just the next time you fill your gas tank.

  5. 5 Babak

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    Well, if it quacks like a duck, walks like a duck… it is probably a duck. But don’t take my word for it, listen to Soros, a much smarter (and also richer) man who thinks it is a bubble.

    The problem is that even if we are correct in identifying it as a bubble, it makes it difficult to find with accuracy the top. But it does help you to become wary, to take profits and to pare positions rather than become daring and push ahead with leverage.

    If/when it does burst, you can bet it will SUPER-charge the economy. And as you know the stock market is usually 6 months ahead as a discounting mechanism, so watch it first.

  6. 6 chavez

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    Right we are running out of oil tomorrow. Let us buy more crude contracts, and put all your 401k, IRA money in USO. Crude going to $1000 by end of 2008, and $10000 per barrel by 2010.

  7. 7 hammster

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    LOL, George Soros?? I lost all respect for him when he failed miserably to rescue Bluefly.com, a rinkydink clothes retailer. He was so inept with that failed investment, I wouldn’t listen to him if he was predicting his own family’s next vacation.

    TREND = Supply of oil is decreasing and demand is increasing.

    My theory, not that I’m any smarter than the so-called experts, is that the era of CHEAP oil is over, and oil’s recent rise is simply a correction for years of oil that was too cheap. Many of you will point to Exxon’s profits but it was the justice department that allowed #1 to merge with #2, Mobil and destroy most of it’s competition.

    As for Chavez’s comment, I did NOT suggest to buy oil contracts. I said to invest in oil drillers and exploration companies, because the only way to permanently address this problem is to find more oil. There are many oil drillers that are not profitable and need capital to drill exploratory wells.

  8. 8 Bill K

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    Regarding oil. I think the top of this bubble will be after more people are converted to hammster’s way of thinking. Right now there are too many people doubting that oil can go higher and are getting their heads handed to them by shorting it. As soon as a larger majority of people give up on that idea and concede that it can only go higher we will put a top in. Now if there were some way to measure the number of people in the oil bearish camp it might be a little easier to pick a top on a contrary basis.

  9. 9 Batman

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    This is a Goldman Sachs conspiracy trade. This is their self fulfilling prophecy being completed by their energy desks. With the co-operation of friends in North American financial power bases. Hank “Goldman” Paulson and Mark “Goldman” Carney running the Bank of Canada, both will continue to lower interest rates (Paulson via Lapdog Bernake) and force inflation/dollar hedgers to own oil until the dollar shows signs of life and a turnaround.

    The oil bubble will only break when these slaves of Goldman and the Bush Admin is done supporting the oil lobbyists that put the fool in the White House. The next admin will be forced to raise interest rates to save the economy and as the dollar strengthens the price of oil will come off. Unfortunately, the amount of pain America will face next year will be far greater than what it could have been had Bernake just leave rates alone. He should have made Wall Street take its medicine and allowed for more Bear Stearns collapses. Instead, as history will show, their actions will have made things far worse, and prolong the recession by several years more than necessary as the price of oil kills the consumer via rising gas and food bills, and reduces the profit margins of some of Americas largest employers, forcing greater layoffs.

    Enjoy the run while it lasts, the next Bear will make the TECH collapse look like a weekend at the beach.

  10. 10 Babak

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    hammster, you lost all respect for Soros because of bluefly? the whole capitalization of BFLY isn’t even a rounding error on his bank account! LoL

  11. 11 chavez

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    hammster, thank you brother. We need more people like you to help us (the oil producing countries). Please tell all your friends to buy USO if they are not familiar with oil futures.
    Crude going to $1000 soon, and so on forever. May be there will be a day when crude will be more expensive then diamonds (let alone gold).

  12. 12 hammster

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    Sorry, Chavez, my investments in US oil drillers only helps to lower oil prices, not raise them. They don’t teach you investments over there in Venezuela, no?

    That’s like saying investing in companies that produce hybrid vehicles is like putting more gas guzzling cars on the road.

    I’m not your brother. I think he’s in Cuba in a hospital somewhere.

  13. 13 Mark

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    This string caught my attention, but still a little surprised there isn’t as many comments as I expected. I’ll keep checking back since this is a hot topic for me personally.

  14. 14 Weldon Thurston III

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    Soros, unfortunately, has been saying that oil prices were at speculative bubble levels at $50 per barrel. Soros, I suspect, is really out of touch with the current reality and is basing his opinion on a past reality that no longer exisits .. at least for now.

    Prices began to have an impact on demand for refined products in the mature western economies in 2005 but demand in the developing economies continued to grow unchecked — in part because government subsidies and price controls insulated consumers. Doesn’t that sound familiar? Washington D.C. did the same thing in the mid-1970’s.

    For the first few years of the hyper-rally, oil exploration companies viewed prices to be at unsustainable levels. After major crude oil reserves are discovered, development projects now take 8 to 10 years to complete. I look for a substantial increase in global crude oil production beginning in 2012 or 2013. By that time, demand for gasoline in the western economies of Europe and North America will have declined for 4 to 5 years. Prices will crash — not because trading activities created a bubble — but because of the inevitable boom and bust cycle.

  15. 15 Pablo Pena

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    > - George Soros

    I agree with Mr. Soros entirely. But this was written in May of this year and the current economic collapse or at least ‘drawdown’ will mean seriously tightening supplies. At least in the mid term oil prices are falling.

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