Here's Why You Shouldn't Be Worried about Oil's 2-Point Drop Yesterday
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Here’s Why You Shouldn’t Be Worried about Oil’s 2-Point Drop Yesterday

by | published October 5th, 2018

Most of my recent Oil and Energy Investor editions of late have been about conditions in the oil market for one simple reason:

The price of crude has been the point from which the overall energy sector has been balanced.

Take yesterday, for example.

During a much broader market meltdown, both crude oil benchmarks retreated.

American benchmark West Texas Intermediate (WTI) closed down 2.7% at $74.33 a barrel, while London benchmark Brent was off 2.3%, settling at $84.64.

And yet…

Even with yesterday’s decline, WTI is still up 9.7% for the month; Brent doing better by 10.4%, with both prices moving back up again this morning.

My prediction earlier this year was that oil will jump to $100 a barrel – and this is looking to be increasingly prophetic.

Here’s why…

Why $100 Oil Is Imminent

The wide analyst consensus is for significant pressures leading to increased prices, irrespective of occasional reductions.

For all the reasons I have discussed here in Oil and Energy Investor previously, the world crude oil balance will continue to constrict with further declines in exports coming from Venezuela, Libya, and Nigeria, even before the slide kicks in from Iran.

My most recent estimate of $90 Brent by the end of this year may now be too low, and movement to $100 barrel appears virtually inevitable.

The factors determining how quickly this happens are three-fold:

  1. how rapidly (no longer whether) Iranian exports decline after the imposition of U.S. sanctions,
  2. the plateauing of Russian prospects for sustainable increases in their own trade volume, and
  3. a ceiling on U.S. exports into the global market, a result of limited increased capacity in port and infrastructure.

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Any realistic way we look at this, international exports will be constrained. The higher prices will create difficulties in major crude importing markets such as India and, less seriously, China. That normally translates into lowering end-user interest.

Nonetheless, demand continues to surge in Asia, and more particularly, China, and that is the region progressively coming to control the international prices of crude oil – and energy in general – moving forward.

Perhaps more telling, everybody in my network of global sources is predicting triple-digit Brent prices by the end of first quarter 2019.

The clearest indicator is this…

How Oil Trading Influences Its Price

On September 20, I recommended here in Oil & Energy Investor the United States Brent Oil ETF (BNO) as both a straight play and as an option “strangle.”

I made the argument then that Brent was more susceptible to upward crude pricing pressures because it was the benchmark used in most international oil transactions. As a result, BNO is the better investment indicator of how global factors influence oil.

Despite a noticeable decline in yesterday’s trading, BNO has nonetheless risen 8.4% in value since September 20. The call portion of the January 2019 strangle, had a final trade yesterday at $0.85 – up 112.5% so far – in only 11 trading sessions!

It had been better by 152% a day earlier and shows every likelihood of surpassing that higher return in the near-term. That is why I am holding off on advising when to sell.

Okay, so why the dive yesterday?

First, investors where certainly looking for an excuse to cream profits off the table in what has been a very rapid spike in prices.

Second, and more nuanced, the high movement up in prices has turned this market into one controlled by speculation.

In such an environment, very brief opportunities to move on short plays (those profiting when underlying prices decline) were paramount. This has little to do with real market dynamics and more to do with the ability of making a profit in very tight (and narrow) episodes where the price declines.

The combination of higher U.S. production, rising interest rates – translating, among other things, into an improvement in the value of the dollar against other currencies – and increasing volatility provided that window.

I’m not only bullish on oil prices… this market is about to explode. Here’s why…

For example, an investor shorts an underlying security or commodity by borrowing it, immediately selling it at market, and then returning to purchase (and return) the contract before the short expires.

Of course, there is theoretically no limit to how much an investor could lose if the underlying security or commodity increases in value. It still must be bought back at market value at some point.

Some short players have made money in the current transactions, although they are likely to be forced to close those positions quickly. What does this say about the forward pricing for oil?

Here is perhaps the most telling observation of all…

Oil’s Rise Brings Forth Profit Opportunities

As I have noted before, paper barrels (futures contracts) drive wet barrels (actual oil being traded).

The paper is set by traders who must factor in risk when determining where to peg the price of oil at some future expiration date.

In such a situation, the futures trader will peg the contract to where he or she believes the price at expiration is likely to be, offsetting that move with options. In a normal market (and aside from academic models, do we even have such a creature anymore?), that translates into the expected cost of the next available barrel.

However, if the perception is for prices to be rising, the upside is the one on which the trader believes the main risk resides. Therefore, the basic approach is to peg the contract price at the expected cost of the most expensive next available barrel.

If that is still the case, one would expect that long contracts – those expecting oil to rise, especially over a more extended period – would outnumber short contracts – those in which the price is expected to decline over a briefer period.

Here is the important takeaway on this point.

Despite a move into short contracts during the past two days, the market preference is still decidedly for long holdings.

No doubt, the hiccups will continue. But there are no substantial impediments to the price of oil continuing to rise.

Which means we’ll be seeing substantial profit opportunities in the very near future.

Sincerely,

Kent

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