Despite the best efforts of the wind and solar power industries, light sweet crude oil (West Texas Intermediate) remains the most traded energy security globally. Contracts amounting to three billion barrels’ worth stay open on any given day. As oil production figures are typically given without even a hint of context, it helps to think of this as about 33 days’ worth of global oil production. Lately, those contracts have traded at levels that portend doom or at least concern for lots of players in the market. And indirectly, the rest of us.
Not All Oil Is Created Equal
First, a little nomenclature review for light sweet crude oil (West Texas Intermediate), because any noun that carries six adjectives deserves a closer breakdown.
“Crude” is self-explanatory—unrefined petroleum that is still fundamentally the same as when it was underground. West Texas Intermediate is the definitive grade of oil exchanged in the Americas and Europe. In that region of the world, if you are a trader dealing in “oil,” it is understood that you are referring to West Texas Intermediate. (Much in the same way that the 30 stocks of the Dow stand in as a metonym for “the market.”) Most of the rest of the world instead deals in Brent Crude, named after the Scottish oil field located halfway between Shetland and Norway.
“Sweet” means low sulfur, in West Texas Intermediate’s case around .24% by weight. Contrast that with, say, oil extracted from the Mars platform in the Gulf of Mexico, which can have 10 times the sulfur content. “Light” means low viscosity oil with a density under a particular (but varying) numerical threshold.
Oil Separates. So Do Oil Prices
For decades, Brent and West Texas Intermediate traded more or less in lockstep. But recently, West Texas Intermediate futures have risen across the board, from two months out to eight years out. Never mind that oil prices (and to a lesser extent, retail gas prices) are at constant-dollar 12-year lows, bringing joy to drivers everywhere. Any price movements (or predicted price movements) of any commodity are enough to raise concern among more jittery investors.
Let’s start in the short-term, two months out. Recent prices for said futures have declined 30 cents a barrel to $45.40, implying a slight decline from today’s current spot price. In other words, investors on balance are guessing that the market, however deflated it might be, still has a little more air that can be sucked out.
Every Movement A Factor
The underlying reasons for the price movements might not be important in and of themselves, but they can predict either future movements or investor predictions of future movements. The general fear is that production will fall. Not because the wells will run dry, but because the cheaper oil gets, the less economic sense it makes to produce it in the same quantities. Or so the thinking goes.
But it is only the short-term movements that are trending downward. The prices of the futures contracts continue to rise as we go farther out into the future. Which means that investors believe that prices will fall in the short-term and rise in the long run.
If futures investors are perfectly efficient, and neither buyers nor sellers are leaving any profits on the table, West Texas Intermediate ought to sell for $58.78 a barrel come January of 2020. Assuming a modest 1½% rate of inflation, that is more than a 20% bump. Substantial, but still not enough to get oil prices up to anywhere near their triple-digit peaks of late 2013. Even if the futures price turns out be an underestimate by 20% or perhaps as much as 30%, that still doesn’t allow for any scenario under which oil producers can enjoy per-barrel profits like they did as recently as a couple of years ago. And that is why most investors are ultimately bearish on oil.
Reducing Supply, Increasing Demand
Of course, oil producers – the companies whose job it is to actually extract the stuff – aren’t going to dig new wells without expectation of a return. Rendering a rig inoperative is a relatively simple task, and thus the number of rigs in West Texas’s Permian Basin has fallen by more than half in the past year. Yet production from the existing wells remains high enough to set records.
The oil industry might think it is special in this regard, but it isn’t. Attempting to predict prices and quantities in order to make informed decisions is something that every person in the world has to deal with, from the woman who owns the neighborhood dry cleaner to the farm supply wholesaler who supplies fencing to cattle ranchers. Yet for some reason, oil speculators’ plight is better publicized.
You often hear the word “glut” bandied about when looking at oil futures prices a few years hence; the fear being that producers will overestimate supply and force prices so far down that they will affect profits. There are so many variables to consider here, it can be impossible to take them all into account. Many oil speculators try to divine meaning out of fiscal policy, the Fed’s manipulation of interest rates, etc., as if those numbers would affect the petroleum industry with greater impact than they would other sectors of the economy.
The Bottom Line
Oil speculators obsess over supply and perceived supply. If you plot the next few years’ worth of futures prices for West Texas Intermediate, you see a pronounced curve heading northeast with great alacrity. The market by necessity must lag behind the production and consumption. High prices in the early part of the decade inspired plenty of exploration and drilling, which increased supply, which put downward pressure on prices, which increased demand, but not so much that it compensated for the lower prices, etc. One thing we know about the market is that it will never be static. There’s no empirically optimal ideal intersection of price and quantity, nor can there ever be. All investors can do is hope to examine the data objectively while not being swayed by the more fickle participants in the market.
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