The business media is having a field day with falling oil prices. There is a parade of oil experts on the air waves making forecasts on where they think that the oil price will find a bottom. Eventually some of them will guess right but no one knows for sure.
I have shared my opinions on the oil sector in previous posts. I decided to do some additional research on the subject and share some of my findings. Oil is sold on the futures market which is a centralized market place for buyers and sellers from around the world. The futures contract will state the price that will be paid and the date of delivery.
A simple example of a future contract
Let’s pretend that you are a farmer that produces tomatoes. To cover some of your farming expenses you could sell a portion of your crops in the futures market to a ketchup maker. The farmer has a guarantee price for some of his crop to be delivered sometime in the future and the ketchup maker protects itself from a possible shortage of tomatoes. The oil futures market works the same way.
Problem # 1 Oil Hedges
No one really knows have many oil producers have sold their upcoming production at higher prices using future contracts. These producers will not stop pumping oil because they have a guarantee selling price that is higher than current prices.
Problem # 2 Storage
Oil wells from fracking technology have a short life span, somewhere between 12 to 18 months. They can’t stop pumping or they will lose the oil in the well. How many wells will continue to produced and put their oil into storage tanks? (There has been an increase in demand for oil tankers to store oil.)
Problem # 3 Short Selling
How many buyers of oil futures contracts at higher prices are trying to reduce loses by shorting contracts? How many speculators are short selling oil futures driving the price even lower? Hedge funds and big U.S. bank’s trading desks have a long history of short selling in the futures market.
DEFINITION of ‘Short Selling’
The sale of a security that is Not Owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security’s price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by SPECULATION, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders who are familiar with its risks.
Sometimes I find that my research raises more questions than answers. My common sense tells me that the price movements in oil futures reminds me of an old 80’s movie.
Story line – On the commodities trading floor, the Dukes commit all their holdings to buying frozen concentrated orange-juice futures contracts; other traders follow their lead, inflating the price. Meanwhile, Valentine and Winthorpe sell futures heavily at the inflated price. Following the broadcast of the actual crop report, showing that the orange crop will be normal, the price of orange-juice futures plummets. Valentine and Winthorpe buy back their futures at the lower price from everyone but the Dukes, turning a large profit. The Dukes fail to meet a margin call, and are left owing $394 million.
Is it possible that the supply / demand imbalance isn’t the whole story behind the current prices for oil future contracts? Is it also possible that the $100 per barrel of crude oil was inflated by commodity traders?
I don’t know the answers so I am staying on the side-lines and let the big players in the commodity market fight it out. I will buy when there is blood on the street.
Not everyone agrees with me:
The U.S. Oil Fund ETF has attracted investor money this year, with the fund ranking fourth in fund flows at $413 million, according to ETF.com. The fund uses derivatives to track the front-month oil contract and is getting pounded, down 15.4 percent year to date. Also, despite its underperformance the Oil and Gas ETF is pulling in money as well, drawing a net $279.5 million in inflows even though its performance also has been dismal, down 9.8 percent.