What The Oil Is Going On?
ByMirroring investor’s expectation of better times ahead in the near future, is the expectation of higher oil prices. Demand is only part of the equation for oil prices. As it has become a hot commodity in the last few years, other than the last half of 2008, it has been speculators and hedge funds that have pushed the price up. Typically, oil trades at its marginal cost of production over the long-term. I would not use this as an entry or exit point in a trading strategy, but it helps to establish if oil is over-valued or under-valued. Currently the marginal cost estimates are approximately $60-70 bbl. In May of last year I was recommending investors take their profits (based upon seasonal strength) at $135 a barrel. People seemed surprised at my recommendation because the consensus at the time was that oil could go much higher. The rest is history as oil crashed to the $40 range.
What should we expect for price of oil to be in the near future? It is important to realize that we have finished one of the strongest seasonal trends of the price of oil increasing up to the beginning of May. Oil stocks (XOI) have increased 24 out of 26 times from February 25th to May 9th. From a seasonal point of view oil can increase or decrease at this time, but its movements are random and it is typically not a good time to place an oil trade.
Just like investors pushing up the market anticipating an economic recovery, investors are pushing up oil prices on the same expectation. Taking a long position on the oil sector is a very risky proposition at this time because of the leverage being applied to expectations. The price of oil has gone up substantially, but yet demand has not increased. In fact demand has decreased and there is so much oil out there that there are plenty of tankers full of the stuff, tied up and being used for storage. In addition hedge funds and oil companies have been taking advantage of the contango trade. Instead of selling the oil today they are storing the oil and sell it forward for delivery at a future date. With the dynamics in the marketplace, it is possible that if the current trends continue, there will be no more storage space for oil in four to six weeks.
Sometimes betting on a large improvement in the future can be a wise trade, but you have to know the price that you are paying. Given that at this point, oil is extremely levered to a strong economic recovery, there is a lot of downside risk if the economy does not expand as expected. In my books, on a risk-reward basis, a long position in the energy sector at this time is not wise.
