The Correct Price for Crude Oil

With the flattish nature of its action over the past several months, oil seems to have reached a tipping point on price.  It's almost as if the charts are saying that oil either must break up or break down, if long-term trendlines are going to be respected.

Barrons took the opportunity to plump for a downside break last weekend, a prediction I have vigorously argued against in both print media and on-air.  But one follower of mine made a very astute observation, pointing out to me that futures markets for crude oil ten years out are 'predicting' oil prices almost $20 lower.  The disconnect between forwards trading as 'predictors' of future price is a subject I spent a long time explaining in my book, "Oil's Endless Bid", but worthy of explaining again - And even pointing out one of the great (at least theoretical) investment opportunities which anyone in the world could make.

A very brief overview of the history of financial oil is necessary here.  Think back into the days before 1983 when there were no financial instruments on oil.  Prices were arrived at using physical trade alone - you delivered crude and cash would change hands.  The price that was agreed upon was arrived at by only two kinds of players - those that produced oil and those that used it.

But the market then was extremely biased towards the takers of crude.  While oil companies had practically limitless capacity for production, the true end users of oil -- consumers filling gas tanks and heating their businesses and homes - were entirely disengaged from those markets.  Production increases were what the big oil companies were after and higher prices were obviously needed to help fuel that growth.  What you had preventing that from happening in those years was an utter lack of buyers meeting a surplus of sellers.  This was the genius of the investment banks in the late 80's and early 90's, developing an army of financial 'buyers' of oil to hike prices and give the oil companies the other side of the oil trade they had been craving.  

Jump forward to the 2000's and today.  Financial 'buyers' of crude now entirely swamp out the legitimate sellers of physical product, adding a premium to the 'prompt' price of oil through managed futures funds, ETF's and other commodity indexes.  

It is imperative to remember that financial buyers of crude are almost exclusively front month buyers - the shape of the curve of futures prices therefore literally tracks what the financial players are doing.

For example, during the financial crisis of 2008, with all the credit gone, financial players mostly fled the oil markets - and front month crude was $20 cheaper than back months.  You could say that only the "real" players were in the markets then, as if it were again circa 1983 and oil producers couldn't find buyers - for a short time, at least.  

But today we see front month crude running at a premium, particularly to far back crude. Here we could say that financial players are very much engaged in the markets, adding their premium to front month crude prices while leaving the very far back months again to the 'real' players.  

Of course the conclusions you could draw are that $77 crude  -- the price represented in far back futures - more closely represents the fundamentally 'correct' price for crude oil, and I would agree.   In fact, that was the thesis of my book.  

And if you believed that oil was going to continue its upwards march, you might also conclude that back month futures represented some of the best investment  'value' out there.  In fact, I have made consistent money buying back month futures and waiting for it to migrate towards the spot month.  Unfortunately, deep margin and maintenance costs make it a difficult and expensive long-term trade.

The bottom line is:  The oil curve is historically a horrible predictor of future oil price.