As I’m writing this, the West Texas Intermediate (WTI) has surged almost 3 percent for the day, over 5 percent since the close on Monday, and is up 6.5 percent in a week – their highest levels since the beginning of February.
Meanwhile, Brent has registered equivalent gains of 2.9 percent, 4.6 percent, and 6.5 percent, respectively.
Now, there are two essential reasons why the price improvement is taking place, and both bode quite well for investment returns in the sector.
Oil’s “Usual Suspects”
The first reason goes to the “usual” suspects…
• U.S. production levels;
• Geopolitics;
• Demand;
• And currency exchange rates.
These are familiar, traditional, and market-based considerations.
American extraction came in much lower than expected for the week. Estimates from the Energy Information Administration (EIA) showed a decline of 2.6 million barrels. However, analysts had expected a 2.5 million increase.
Now, a variance like this is hardly news.
In fact, the EIA and analyst expectations tend to move in different directions over 60 percent of the time.
Somewhat unusually this time around, however, was the convergence between the EIA and analysts on the two-other major weekly figures – gasoline and distillates (diesel and low-sulfur heating oil).
Only crude oil showed a marked disparity.
Now, geopolitics can once again be used to explain all manner of events in the energy sector.
This time, we can point to concerns over…
• Rising instability in the Persian Gulf as the Saudi Crown Prince visiting D.C. as Trump considers ending the Iranian Nuclear Accord;
• Washington considering sanctions against an imploding Venezuela;
• The intensifying Libyan conflict;
• Chinese saber-rattling in the South China Sea;
• And ongoing Nigerian domestic problems, to name a few of the more compelling, I often note that geopolitics are no longer an outlier when considering the energy markets.
I often note that geopolitics are no longer an outlier when considering the energy markets.
Rather, the uncertainty resulting from cross-border and global unrest is an ongoing staple element.
Nonetheless, pundits often use it as a catchall for anything they have difficulty explaining.
Geopolitics may influence how one regards the potential future oil availability, but until the oil flow is actually impacted, its influence is more apparent than real.
The Misunderstood “Yardstick”
Demand remains one of the most misunderstood yardsticks to measure oil.
Yes, the balance between supply and demand certainly does influence price, but the real importance is the effect it has on the amount of excess supply.
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Oil requires available volume beyond what the market needs at any time to narrow the pricing range. Of course, too much excess volume will prompt prices lower, while the opposite will drive prices higher.
When we speak of a “balance,” it always assumes the availability of excess volume beyond immediate requirements.
That balance is rapidly emerging and, in some regions, may have already arrived.
Finally, currency exchange rates speak about the foreign exchange rate for the dollar. The vast majority of all international oil trade is denominated in dollars. When the value of the dollar declines against other currencies (especially the euro), the dollar value of a barrel of oil increases.
And recently, the weakening dollar has resulted in that upward pressure on crude.
Oil’s Perceived Price
Remember, the one common thread permeating all of this is how the forward price of oil is perceived by the trader.
Here, as I have noted, traders will peg the price in a future contract to the expected cost of the next available barrel of crude.
Options – and more exotic derivatives – are then applied as insurance against movements in either direction.
Throughout all of this, the perceived direction of prices becomes the driving engine in traders’ actions.
If that perceived trend is moving up, traders will compensate by setting future prices based upon the expected most expensive next available barrel.
The opposite, as in the least expensive barrel, governs the mindset if the trend is moving lower.
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Keeping this in mind, therefore, the most direct way of concluding which way it will move is rather straightforward.
It involves the number of short versus long contracts being exercised.
A short is run if the trader expects the price of any underlying commodity or equity is going to decline. Conversely, a long contract anticipates the underling will rise in price.
Until last week, shorts held considerable sway.
That changed abruptly on Thursday with long contracts taking over.
The New “Head Honcho”
Longs are now driving the market.
Another result of this transition is the need for holders of shorts to liquidate positions, requiring that they go back into the market and purchase contracts.
That serves as another upward pressure on prices.
Related: Is Another Oil Price War Looming?
All of this evens out at some point into a new equilibrium.
After all, that is what trading markets always seek.
But the important point to remember is this:
It’s not the ceiling, but rather the floor of the pricing range that actually determines the direction of movement.
Once the dust settles, if the floor is rising, so are the pricing expectations.
That is what we have at the moment. And that’s all we need to make money with targeted moves.
By Dr. Kent Moors
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The truth behind oil’s recent price spike is plain and simple: the robust global demand and a virtually re-balanced global oil market. Of course, there are other factors that could push oil prices up such as a major disruption in a major oil-producing country and also geopolitics.
But we have to remember that geopolitics could push oil prices up only when the market is balanced or nearly rebalanced. We must remember that oil prices during 2016 and 2017 refused stubbornly to rise above $45-$50 a barrel despite escalating tension between Saudi Arabia and Iran, the Iraqi war on ISIS, the Syrian/Russian war on ISIS, the referendum for independence in Iraqi Kurdistan and the harsh war of words between the United States and North Korea. The reason is the glut in the oil market neutralizing these geopolitical events.
However, now that the oil market is virtually re-balanced, geopolitical events such as a potential trade war between the United States and China, the launching of China’s crude oil futures contract on Monday the 26th of March this year and the appointment of John Bolton as National Security Advisor could boost oil prices.
The appointment of John Bolton who is known to be an extreme neoconservative, does not bode well for the Iran nuclear deal or the civil war in Syria. He will egg President Trump to start a war with Iran or get the United States more involved military in the Syrian quagmire with destabilizing impact on the whole Middle East and the world at large.
Claims by the EIA about increases in US oil production and rises in US crude and gasoline inventories no longer have an impact on oil prices as the global oil market no longer believes them. The EIA tried tirelessly all through 2017 to keep oil prices within a shale band of $60 ceiling and a $50 floor but it failed. Now it is trying to keep oil prices within a $70 ceiling and a $60 floor but it will fail again. Oil prices are going to reach $70-$75 in 2018.
And since oil is priced in US dollar, a decline in the value of the dollar against other currencies enhances oil demand and that should in theory push oil prices up. Instead the oil price actually goes down. The reason is that by devaluing the dollar, the actual purchasing power of the oil revenues of oil-producing nations declines against other world currencies forcing them to raise oil production to maintain revenue thus depressing the oil price.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London