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What Crude Oil Prices Are Telling Us

by | published October 1st, 2010

Three days hardly make a trend, but the spike in crude oil prices we witnessed this week is a harbinger of what I’ve said is coming…

On Wednesday and Thursday of this week, equities declined, but oil went in the opposite direction. Today, both moved up at the open, but while equities stabilized, oil just kept right on marching.

As I have noted on several occasions, oil has taken on a life of its own. It is both a commodity in wide demand, and a financial asset in its own right.

In the former case, as a commodity, the so-called “wet” barrels (the actual oil) will respond to traditional pressures in the market, led by supply and demand considerations.

The latter, playing the asset card, involves futures contracts (the “paper” barrels). Oil becomes something that can be used as a store of value. And this is underpinning a crucial new development (as we shall see in a moment).

Five dominant factors prompting the rise in oil prices right now are well-known by the market: currency exchange considerations, inventory, industrial performance as a measure of returning demand, supply constrictions, and mergers and acquisitions (M&A).

But it is a sixth underlying element that provides the pervasive reason for oil marching higher, as well as a significant opportunity for you to make a great deal of money.

What’s Pushing Crude Higher

First, virtually all worldwide oil sales are denominated in dollars. But the local sale of the products refined from the crude is not.

This has its greatest impact on oil in the interchange between the world’s two dominant trading currencies. When the dollar’s value (the forex factor) declines relative to the euro, effective costs in dollars increase, and, thereby, so does the pricing of the crude. The euro has been gaining significantly against the dollar of late.

Second, analysts await the Platts estimate on Tuesday and the Energy Information Administration (EIA) figures on Wednesdays as a gauge of how much crude and processed oil products are in the market. High stockpiles translate into sluggish demand and have a restraining influence on prices. Lower stockpiles point toward increasing demand, concerns over shortages in oil products, and higher prices.

And right now, stockpiles are plunging.

Third is what is usually regarded as the “Holy Grail” of demand by the market in the current situation – industrial performance. Rising output signals an improving economy, more capital spending, and the greater usage of oil products. This is now falling into place.

Six of the 10 forward economic indicators are energy-intensive; that means when they are rising, so is the need for oil. All six are in the green.

Do not try to gauge oil demand by looking at, for example, unemployment. That is a lagging indicator and one of the last to change in a recovery. The market will move up appreciably before there will be any significant improvement in employment.

Fourth, as demand returns, questions surface over whether we have adequate supply to meet it again. As I have said here many times, once the recovery begins in earnest, the supply coming on-line will be hard pressed to meet accelerating demand. (See “‘Peak Oil’ Is Back on the Radar,” September 10th, 2010.)

A recovery cannot take place without increasing usage of energy. And that translates into higher pressure on oil prices.

In the very near-term evaluation of pricing, supply questions translate into constriction concerns. Are there bottlenecks in the upstream/downstream transfer of crude? Do we have refineries off-line or running at reduced capacity? Is weather a problem, or earthquakes, or floods? Are there tanker delays, pipeline explosions, cross-border problems in the Persian Gulf? Are technical glitches delaying volume from coming on-line at fields someplace in the world?

In a tight market, anything can spike prices.

In my role as a TV commentator, I am often asked what the supply situation looks like. During the highs of summer 2008, I once responded, half-seriously: “If a gasoline delivery truck this afternoon has an accident on the Garden State Parkway, it will have an effect on the NYMEX price.”

Well, we are not there yet. But constriction problems are forming. Recurring hurricane concerns, a prolonged dock strike in France, and recent Chinese policy tightening are only the latest.

Fifth and finally, the M&A cycle in the oil sector is intensifying. A number of smaller producers are either being absorbed outright or brought into joint production activities with larger companies. In addition are major investment programs, such as the Sinopec (NYSE:SHI) announcement this morning of a massive acquisition in the Brazilian unit of Repsol (NYSE:REP). Many of these moves will reduce competition, increase the oligopsony (when there are fewer first-stage buyers of crude), serve to concentrate profits, and increase prices.

All of these five factors are now either moving in the same direction (up) or positioning to do so.

For convenience, analysts use equity pricing as a proxy in determining where oil is likely to go. The assumption has been that the price movements in stocks will largely tell us what these five factors (and some others) are doing to the price of oil. In short, crude will follow swings in the equity markets. That seemed to make sense during the depths of the financial crisis and the accompanying lack of credit access.

Not any longer. We are coming out of the recession. And the most important element is actually one sitting just behind these five. While the first five are factors are now recognized by the traditional approach to the market, the sixth is not. The actual engine of price increases as we move forward is a new development…

Don’t Overlook the “Racheting Effect”

As Oil & Energy Investor readers well know, my approach is to guide you to high profits in the rapidly increasing volatility that is already making its way into the oil sector. That is not simply a result of overall developments in equity trading. A volatility index, for example, should show you the uncertainty in a market. That means as the index goes up (indicating rising uncertainty by traders), the market should go down, and vice versa.

Yet check out the Oil VIX for the past several weeks. It is exhibiting values that reflect the equities markets, not crude prices. As the Oil VIX goes down, crude prices go up. As the Oil VIX goes up, crude prices go… up?!

This has been my point from the beginning. We’re dealing with a commodity that is widely required by economies, and that also serves as a financial asset – so volatility acts differently. When we see the “perfect storm” in traditional factors, such as we have been witnessing this week, that underlying volatility assumes a life of its own.

I have even named this underlying factor – I call it the ratcheting effect. Just like the ratchet in your garage moves in one direction to allow a greater movement in the opposite direction, so too will we increasingly see the same movements in oil pricing.

In depressed environments, that ratcheting effect will move prices down – and to a greater extent than the five “traditional” factors would justify. (Just check out what happened between September 1st, 2008, and April1st, 2009.)

The same thing happens when we move in the other direction. And that is where we are heading… and fast. The underlying volatility – the ratcheting effect – will increase prices more than the actual market factors would seem to justify. As a result, two things will happen.

One, I will be giving you specific market players who are well positioned and focused to benefit from this phenomenon.

Second, you are going to making a great deal of money.

Kent

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  1. John Rollins
    October 11th, 2010 at 15:24 | #1

    Should we not be hearing about specific oil etf’s or companies/organisations to prepare for what is clearly coming?
    Regards,
    John

  2. Chuck KinCannon
    October 11th, 2010 at 15:44 | #2

    What is the best way to position for this uptrend? I have been waiting for a correction, but it may not come. Would purer plays such as USO be better or actual companies? How would we play options? Calls?

  3. FinTrade
    March 6th, 2011 at 08:31 | #3

    The crude oil prices are increasing due to speculations. Really Libya is providing not more than 2% from the world capacity of crude oil, so this should not be threated as crisis. Everything is coming from speculations only.

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