The Two Faces of Oil

Oil is a mysterious commodity. It trades with supply and demand numbers, yet it also trades with geopolitical events. It is an international commodity with each country buying or selling depending on their needs and domestic supply.

Since June we’ve seen the sharpest drop in oil prices since the 1980s. This was due to a confluence of factors that came to bear on the price. With an oversupply hanging over the market OPEC refused to cut production. At the same time the United States and Europe imposed sanctions against Russia for its invasion of the Crimea. The economy of Europe grew at a measly .3% pace compared to a 2% rate in 2004. Japan raised its sales tax in early 2014. This led to consumers restricting purchases and driving the Japanese economy into negative growth for two consecutive quarters and the beginning of a recession. China is trying to burst the real estate bubble and is restricting credit. It too has slowed its demand for oil. The United States, despite the steep drop in oil prices will produce more oil in 2015 than it did in 2014.

Oil prices dropped from $115.00 per barrel in June to $45.00 in January 2015. The effects of this plunge have wrecked havoc on the oil industry. It is losing $5.4 billion per day. To be profitable for producers oil has to trade at $50.00 per barrel of higher. Right now, half of the oil projects are not producing a profit.

Supply/Demand

Currently we have a global oversupply of 1 to 1.5 million barrels per day. The United States is producing 9.3 million barrels.. OPEC produced 160, 000 barrels per day in January.
Stockpiles are rising fast. The Energy Information Administration (EIA) estimated that stocks rose by 10.1 million barrels in just one week.

Oil Drilling Performance

One area where we see the immediate effect of the oil glut is in the use of oil rigs. Helmerich and Payne, a big rig producer has laid off 2,000 employees. It has cut construction from 4 rigs down to 2 per month. It now has has 200 rigs in operation, down from 297. The cost of operating a rig has dropped from $29,457 per day to $27,500. Baker Hughes another large rig producer has shut down 94 rigs. Overall we have 1,233 active rigs, a drop of 94 to date.

Technical Factors

The price of oil futures contracts is now in a Contango. This is when the price of forward contracts is higher than the spot price. This is what a Contango looks like: Oil contracts are traded each month but for this example we will use quarterly prices. As of Friday February 13, 2015 these are the closing prices: March $52.78, June $56.25, Sepptember $59.55, Decomber $64.90, March 2016 $65.29, June $65.79, September $66.11 and December 2016 $66.62.

Producers are using this spread to hedge their oil production. A hedge is a simple concept. If you own the physical product, you sell futures contracts against it locking in the profit. For example, with March 2015 oil selling at $52,78 and March 2016 selling at $65.29 you can lock in a profit of $12.51 per barrel. However you must be willing to pay for storage of your oil and hold it until next year.Hedging, while simple, requires a specialist trader who knows when to sell physicals and/or lift the hedge by buying back the futures contract.

Oil prices had a sharp bounce from the $45.00 area to $53.00 creating a V bottom. Part of this rebound was due to the traders sniffing out a possible cease fire between Russia and Ukraine. Talk of a peace deal would eventually lead to a lifting of sanctions against Russia.

Whether the rally continues is a matter of debate. No one really knows where the market is headed from here. For investors, it is best to stand aside and let market forces lead the way.

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