There are several things I like to avoid doing on Friday the 13th.
One of them is predicting where oil prices are likely to be at some point in the future.
As developments have shown over the past two months, that can be a very frustrating undertaking.
Except maybe this time.
Events occurred yesterday that spiked the price of crude oil in London and New York this morning. I'll explain those events in a moment. First I want to make the point that finally, after all the angst over Spanish debt, cross-border credit, the strength of French banks, and the specter of double-dip recessions, we are finally back to the two factors that actually drive the current oil market.
Volatility has been viewed primarily as an emotional matter over the past year or so. Market perception has driven what investors have regarded as the market reality. Much of this has been an overreaction to the most recent headline or rumor running the Street.
Not all of this, of course, is without foundation. But the degree of the response has been well out of proportion to the actual likely impact of whatever is troubling the trading floor at any given time.
Volatility has acquired a life of its own. And that is rendering most of the traditional ways of trading less reliable (or less effective). The swings are more extensive, and the movement is out of proportion to events.
Recently, that has translated into more downward than upward movements in oil prices. That simply means, when we experience a market correction, that correction will be quicker here than in other sectors.
And we are on one of those now. Softness in the oil market, brought on by some realistic concerns over demand and economic recovery prospects on both sides of the Atlantic, should have resulted in about a 9% decline in crude prices between early May and late June. Market overreaction, and the expanding volatility it ushered in, brought about a contraction of some 21%.
As I write this shortly before open, the West Texas Intermediate (WTI) benchmark oil price in New York is up over 11% from its low recorded in late June. It is increased over 1.2% so far today, and almost 3% for the week.
Brent futures in London are up 14.8% since lows at the end of June, 1.2% today and 3.5% for the week.
The only thing of consequence has been a progressive takeover of the pricing mechanism by the underlying dynamics in oil itself. For all the talk of lowered demand, historic stockpiles and the business investment-employment tradeoff, what actually should be driving oil prices has remained the same.
Normal global demand projections remain a concern, as does the adequate supply to meet it. This does not mean we have an impending shortage approaching. But it does mean that the balance equation in oil itself is a built-in guarantee of rising prices.
So long as that balance is the focus, not the hype provided by talking heads on TV who run from the interview to short the commodity.
This is the real basis for the volatility. It is the collision between the perception market makers want to convey and the reality of what is the foundation of the real oil trade—the spread between the paper barrel (the futures contract) and the wet barrel (oil for delivery).
And we had two events yesterday that are driving the latest headlines. Except this time, those headlines are finally addressing elements that have tangible genuine impact on the price of oil.
The first addressed the supply side and is this morning pushing up volatility.
Then British authorities released figures indicating the production volume from the North Sea is declining faster than originally predicted. Having just avoided a potentially crippling oil workers' strike on one side of the North Sea (Norway), the market learns there is less supply coming in than expected anyway.
That is hardly encouraging for a Eurozone that is dealing with a cut in oil imports—the EU embargo of Iranian oil kicked in at the beginning of the month. We all knew it was coming.
But it does not hit the market until it affects actual crude delivery contracts. And that is just beginning as we move into the third quarter delivery schedule (the first under the weight of the embargo). That is now taking place.
It also leads us into the second factor—the geopolitical.
Iran has apparently been able to schedule August deliveries, but it is becoming more difficult, and the profit margins are lowering. That is because other EU, U.S. and U.N. sanctions make it harder each month for Tehran to access international banking and foreign exchange.
These remain essential for Iran to sell its oil abroad and import needed gasoline and heating oil into an oil-rich country with an insufficient refinery base. That has obliged Iran to use inefficient and more expensive ways to process trade.
Well, yesterday, the U.S. increased the stakes by taking action against Iranian-related companies and individuals Washington that has concluded are facilitating Iranian arms trade and nuclear program development. Turns out, many of these are also the venues being used by Tehran to bypass the banking restrictions.
Iran will react and that means Europe is waiting for the other shoe to fall. Therefore, it is hardly surprising that Brent is heading north faster than WTI. That means the spread between the two benchmarks will widen, virtually guaranteeing another element increasing prices.
The U.S. may have found significant resources of domestic unconventional oil (shale, tight, heavy, bitumen) and Canada has vast reserves of oil sands. Both make America less reliant on imports.
But this is still an integrated global oil market. The demand forces pushing the market are not North American or European. Regardless of the increasing domestic sourcing in the U.S., the wider market will still determine the price.
And the combination of volatility and geopolitics is setting a higher floor for crude oil moving forward.
Oil & Energy Investor