The Swift and Violent Rise of Oil

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". . .if you judge traders by their actions, you can see the market is setting up for a big oil back draft."

Why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term—and maybe that's not totally a lie.

After all, the current oil price results from two factors:
  1. The absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production).
  2. Oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.
Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010):
  1. The lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with, but the crash in prices has put the kibosh on exploration and production.
  2. As Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike explains in his story.
One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world's largest oil exporters face declining production trends thanks to—you guessed it—peak oil.

Peak oil has not gone away. It's been sent to the corner while the credit depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a "swift and violent rise" in oil prices in the second half of 2009. "Thirty dollar oil reflects the same imbalances that got us to $147 oil," Currie told a conference in London. "The problems haven't gone away. We still believe the day of reckoning is to come."

Two is that there are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, "This is not 1982–1983 all over again. The supply picture's radically different. . .the demand picture's radically different. The key difference is that today there are no large-scale next-generation projects that are going to save the world. Commodity demand is exponentially higher than it was."

This brings us to the third reason oil prices should rise later this year—the oil trade is back on. Sure, credit may still be a scarce commodity; but, if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, "Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year," two shipbrokers said.
Our friend Dan Amoss calls this the "oil arbitrage trade," where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What's less normal is the amount of oil being stockpiled offshore. Frontline Ltd., the world's biggest owner of supertankers, said Jan. 14 ". . .about 80 million barrels of crude oil are being stored in tankers—the most in 20 years."

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What's more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

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