Over the past few weeks, you’ve seen me mention oil pricing “floors” more than once. Judging by your emails, many of you would like to know more.
So today, we’re going to delve deeper.
But first, let me restate the crucial point: establishing a floor in oil pricing (a price that oil won’t dip below) is what generates the ability to make money – for oil companies as well as for you as an investor.
So you’re better off ignoring the anxious talking heads on TV who are concerned about whether oil will break the $50 a barrel “ceiling” or not. Instead, what’s important is that oil is now unlikely to dip below $42. That’s the floor – and your signal that a stable pricing band has formed.
That’s especially true today…
Oil Bounced Off its Ceiling – But the Floor is what’s Important
Crude oil prices are once again settling in the range that I’ve been predicting for some time: West Texas Intermediate (WTI), the benchmark rate for futures contracts in New York, having a ceiling price of $48 to $50 per barrel by mid-June.
As of close yesterday, WTI was at $48.16, while dated Brent (the other primary benchmark, set in London) was $48.85. Furthermore, the spread between the two – calculated as the difference between the two viewed as a percentage of WTI – has now come in below 1.5% for two sessions in a row, pointing toward the price once again approximating an actual market indicator.
WTI has now risen 83.7% and Brent 58.4% from their respective lows this year, both only three months ago on February 11. Now, as I’ve been predicting in several of my research services this week, oil’s current rise is just about over.
External factors have certainly contributed to the recent spike: spreading wildfires in Western Canada have combined with intensifying insurgent control of oil installations in Nigeria’s Niger Delta to offset apparent improvements in Libya’s ongoing civil war (the third main external element).
Pundits (perhaps trying to prompt a decline in oil prices for their own ends) are quick to point out that these factors are (1) hardly permanent and (2) have no impact on the continuing oversupply weighing down upon the market.
Both are true – but don’t go nearly as far as their proponents think they do…
Reserves are Responsible for the Ceiling, not Supply
It’s true that none of these crises will last forever. On the other hand, geopolitics and Mother Nature remain integral elements affecting oil – several other natural or man-made crises could pop into existence at any time, in any number of locations.
And as for these disruptions having no impact on the oversupply of oil, it’s certainly true that excess oil volume continues in the market.
Yet, as regular readers of Oil & Energy Investor well know, the culprit here is excess extractable reserves. Traders recognize that considerable additional supply could be dumped on the market from the known, easily extractable in situ reserves. It’s this recognition, rather than the physical oil in man-made storage, that serves to temper how high oil prices climb.
However, global demand is once again on its way up. Despite excess production and new expanding sources (Iran’s attempt to return to pre-sanction oil production and export a prime case in point), a balance is forming even in the presence of excess supply.
And remember, the market requires excess supply to provide liquidity in commodity trades. Therefore, oversupply is not automatically a bad thing. In addition, we had significant excess supply in storage or stuck in transport bottlenecks throughout the period of triple-digit crude oil that ended in 2014.
So something else is at work
And it’s here that the main importance of the pricing floor emerges…
Oil’s Price Floor Opens Up the Market
I’ve noted before that a stable range for oil trading results in the best environment for both investor returns and the futures contract prices reflecting the real market conditions of “wet barrels” (the oil actually traded and delivered).
This happens when a floor (not ceiling) forms in oil prices and begins to dictate trade.
When it comes to the commentary on TV, floors are usually considered only if the lows are approaching some significant moving average. You’ve probably heard something like “If the price breaks through ____ then the next resistance is at ____” countless times.
But that’s only part of the picture. The importance of a stable pricing floor extends to what that floor means to traders – how they set their contract prices and insurance (options).
In a stable market, traders peg prices to the cost of the expected next available barrel. That then requires less arbitrage between “paper barrels” (futures contracts) at expiration and wet barrels (the actual consignments of oil).
However, perceived pricing volatility, in either direction, forces traders to change their approach. In the declining market we experienced over the past fourteen months, traders need to hedge their contract risk by setting prices to the cost of the least expensive next available barrel.
Conversely, in a rapidly rising market, traders have to hedge by pegging prices to the most expensive next available barrel (or risk getting paid less than their competitors).
In either case, the rational actions of traders intensifies the up or down movement, far beyond what the dynamics of the market would dictate. Such excess contributions are also reflected in the greater use of exotic (and synthetic) derivatives by those who write futures contracts.
Meanwhile, traders use options to further limit their risk with either wet or paper barrels, again widening the impact of the trading perceptions.
In such cases, the actual price of the underlying commodity is distorted.
It is no small result that a stable pricing floor reduces such distortion. And while the floor hardly stops pricing swings, it does limit the impact by changing how traders view their forward exposure.
And that is enough to open up the market – for oil companies, that can finally get a predictable and reasonable price for their product, and for investors like you, who can ride the rising fortunes of those companies for profit.
If you’ve been sitting on the sidelines of the energy market, waiting for the dust to settle, now is the time to jump back in.
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