Three Items That Will Signal a Crude Recovery

Source:

"Thawing credit markets, increased demand and decreased supply could spark a recovery in crude."

One of the questions I have been asked a lot lately is why oil is so cheap today, when only a few months ago it was ridiculously expensive? Part of the answer lies in the question; it was ridiculously expensive and, despite what every CNBC 'analyst' said, there was no fundamental reason for oil to be $147/bbl. The fundamentals probably stopped making any kind of sense around $75–$85/bbl, so the question is really, why is oil 50% off that price?

What needs to be understood is that the 'price discovery' mechanism for WTI (West Texas Intermediate) crude is NYMEX. One NYMEX WTI Crude contract is 1,000 barrels of oil, delivered in a specific month to Cushing, Oklahoma. I think the initial margin for one of these contracts is $9,113 (assuming you aren't a member; if you are a member it is $6,750). That means with $38,000 of exposure (at today's prices), the average member can use about 5.6x leverage with futures contracts.

The reason why WTI keeps dropping in price is because inventories keep increasing. When inventories increase, traders take it as a sign that demand is low and there is plenty of willing supply at these prices; therefore, the price of oil should go down until inventories stop building (i.e., demand equals supply).

Contango (when you can sell a commodity at a higher price in the future) forces crude into storage. Why sell your crude today for $37 (or in February for $38.79) when you could sell it in March for $45?

What all that means is there are a few things to look for that will set the stage of a crude recovery:
  1. Thawing of the credit markets (which is already well under way). If people could get financing for the carry trade on crude that would drive front month prices up and later month prices down (removing some marginal supply).
  2. Increased demand. This is obvious—more demand could reduce some excess inventory.
  3. Decreased supply. We are already starting to see a decrease in supply from OPEC nations.
Any of those three things could spark a recovery in crude. It's worth noting that two of them are already well underway (though we won't see the results until it's probably too late). So why is crude so cheap?

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