The Key to &quot;Gaming&quot; Oil Volatility
The markets are open again today after the tragic storm across the East Coast. In a world ravaged by storms, geopolitical tensions, rising demand, supply concerns, and increasing costs, it’s important to know what’s really driving the markets moving forward.
The most important thing you can know is that increased market volatility is not going away. The challenge, of course, is to harness these volatile forces in order to come out ahead in the future.
That’s the subject today. First I need to set the picture of where we are today.
There has been persistent talk from the usual sources that the price of oil will collapse, along with a range of field support and midstream service providers.
There is just one problem with this argument.
It’s just not going to happen.
Don’t get me wrong. I am not suggesting that the accelerating volatility in oil will point only in one direction, or that the trajectory is straight up. This is not going to be the first half of 2008 revisited. Rather, we will continue to experience intense movements over shorter intervals.
This is what statisticians call kurtosis – greater amounts of volatility occurring in shorter cycles.
Despite the overall upward trend demanded by indicators, these more compact movements will occasionally go in either direction.
That means we can experience downward spikes restraining oil prices over shorter durations. Nonetheless, the overall medium-term dynamic continues to move up. This is producing what I call a “ratcheting” effect: The market prices will undergo downward pressures within a basic upward tendency.
So where are oil prices going?
I monitor nine factors to determine this. These factors run the gamut from effective in-place field reserves, industrial (not retail) demand, and pipeline/terminal volume usage, through the ratio of refinery inventory to purchasing trends, to geopolitical crises and bottlenecks.
Of the nine, six continue to show pronounced upward indicators.
So why are we not seeing a more pronounced move up in oil prices?
Storms Affect the Short Term
The hurricane season is an external factor restraining prices. The more storms we have, the more often this factor is felt.
When a major storm is approaching, it is not only production and refining that is shut down. It is also storage facilities.
With no place to put additional volume (since the wholesale network is also affected) and no way to manage the transit of that volume, prices decline, because there is neither a need for additional supply nor a place to put it. This is a short-term impact. It’s rebalanced once the danger is past. But it does explain the decline in prices as Hurricane Sandy approached.
We see the opposite with gasoline and diesel.
As the situation obliges refineries to shut down (a process already underway on the East Coast by Monday afternoon), cuts in supply will temporarily boost prices beyond the level where market factors would place them. That remains an issue until refineries are back on line and distribution returns to normal.
But the main reason prices are subdued has nothing to do with what nature throw at us. It doesn’t even have anything directly to do with the underlying realities of the oil market itself.
What continues to depress the prices are concerns about economic recoveries on both sides of the Atlantic. This translates into emotional over-reactions to headlines and pundits’ knee-jerk comments about everything from European credit concerns to the latest inventory figures are Cushing, Okla.
As my colleague Keith Fitz-Gerald puts it, markets are what they are.
And that sometimes includes the race of lemmings to the cliff. Investor exuberance lays hold one day; investor depression the next. Perceptions are now taking the place of reality.
How to Find Balance in Your Energy Portfolio
I have two observations to explain how investors can make money in the face of such perceptions.
First, the continuing argument that prices will slide is not only wrong, it is unsustainable. Unless economic decline is the new permanent reality – and that is neither evident nor possible, even in the most pessimistic of assumptions – the emotional over-reaction will end.
Let’s be clear once again that it is the perception not the reality that drives the doomsayers and short artists in such an environment. As the cycles reverse, prices recover quickly and then move forward. The “professional pessimists” are right only if the price is always declining.
And that simply is not taking place.
Take for example what we have seen recently. From the second week of May to the third week in June, the market experienced a 21% decline in oil prices (when, as I have mentioned several times before, the actual market fundamentals called for only a 9% correction).
Once the lemmings had dried off and the cries that the sky was falling subsided, the prices shot back up. One month later, NYMEX oil prices had recovered all of their losses. Brent in London was actually registering absolute gains.
But here is the important point. Most of the individual stocks in my Energy Inner Circle portfolio are ahead of where they were before the downward pressure hit. The key to gaming the volatility, especially during periods in which emotion is replacing reason, is balancing your portfolio to offset these moves.
Put simply, the energy sector has built in offsets.
When one segment (natural gas production, for example) is declining, another (utilities) is likely to be moving up as a result. Or, if crude oil prices are declining, refineries will pick up because of improved margins.
A balanced portfolio, therefore, allows an investor to both ride out volatility and increase returns.
[Editor’s Note: For a closer look into how the oil market really works, click here. You’ll learn why people calling for $40 oil are dangerously wrong.]
Second, we need to remember what sector is involved here.
This is not discretionary spending or luxury goods.
This is energy.
Nothing – no growth, economic development, or trade – can take place without the energy sector. While markets can ride a rollercoaster of sentiment on the volatility express, all aspects of these markets require energy regardless of where the curve happens to be.
As has always been the case, in every pricing cycle of the past decade, central essential goods always weather the storm (hurricane or otherwise).
And energy is the most central of all.