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Oil’s market price today: where do you want to sit as an investor?

January 24, 2014 by Editor, InvestingForMe

As we discussed in our last article, just like those investors that bought into the gold story (rising inflation due to money printing), most oil investors have also bought into the oil story. You know the one – where we’re told how oil’s market price is all about Peak Oil's diminishing supply in the face of the growing demand out of emerging markets (China et al).

 

 

But what if the oil’s story is missing the same critical link that the gold’s story missed – the important role that investor demand plays in determining the market price?

I know what you’re thinking. Here we go, another one of those oil conspiracy theorists that rants and raves about speculators taking over oil markets and manipulating oil’s market price. But let’s just pause for a minute and think about the what if’s … What if we ignore the role investor demand plays in today’s oil prices? If oil prices do go the way of gold’s prices, what’s going to happen to all our savings that we’ve all got socked away in oil investments?

Ignoring investor demand: the debate continues

Since the introduction of the first ETF in 2006, investors have invested tens of billions of dollars in oil. That’s money that was never available to the oil market previously. And despite how big the oil industry is, investor savings flowing in and out might not dominate oil trading, but it’s now a meaningful part of the oil demand equation and it can have an impact on the market price of oil. In other words, investors can impact oil’s market price with our enthusiasm or our disgust by buying or selling oil ETFs. Simply ignoring investor demand and its influence on oil’s market price (just as gold investors were ignored!), might prove foolish.

But don’t just take my word for it. People whose job it is to study the oil market have warned of this potential risk as well. In 2009, the Commodity Futures Trading Commission (CFTC) held a hearing into the dramatic rise and fall in oil’s prices between 2008 and 2009. During the hearing the CFTC disclosed the role investor buying and selling had on oil’s market price changes. Here’s part of what they said:

According to CFTC data, from January 2008 through the end of June 2008, index investors poured $55 billion into major commodity indexes, pushing the price of crude oil from $99 per barrel to $140 per barrel. Gasoline prices spiked to a national average of more than $4 a gallon, with prices reaching more than $5 a gallon in some regions of the country.

That same market collapsed over the course of the next six months, with prices plummeting to $30 per barrel by December 2008 as investors withdrew $73 billion from the market. This was not a coincidence. The dramatic drop in oil prices was occurring at the same time index investors fled the market. From January 2009 through May 2009, you can see the price rise from $35 per barrel to $70 per barrel as index investors come back into the market and pour in $35 billion into major commodity indexes. – July 28, 2009

So, in plainer words, the CFTC found that in 2008 and 2009, it would appear oil investors believed oil’s story, then didn’t, then did again – causing oil’s price to jump 41%, then drop 78%, then jump 133% again.

Another point to remember when it comes to the danger of ignoring investor influence, is the point that when it comes to an asset’s market price (including real estate, a stock, bond or commodity), the price is never set by the 90% that stick to the story, but rather by the 10% that don’t. So even if oil investors as a group only make up a small percentage of the overall oil demand, they may just be that 10% that can dictate oil’s future price by not sticking to oil’s story.

There have also been a number of studies by academics and others in the oil industry that have delved into investor demand and changes in the market price of oil as well. Interestingly while some have concluded that investor demand is responsible for as much as 70% of oil trading, identifying investor demand as a major factor, other’s have reached the opposite conclusion – that investor demand has no causal relationship with oil’s market price. But the truth is, no one knows for sure, and that’s my point. Investor demand is simply a dark horse where oil’s price is concerned.

To borrow from the U.S. Energy Information Administration’s (EIA) own analysis,

Financial factors include developments such as the growing interest over the last decade in crude oil as an investment asset. This investment interest has altered the financial money flow into and out of commodities.

Some market observers believe that increased trading activity by investors and long-only index funds in oil markets has had a significant impact on the energy price formation process. Although a growing body of research by academics and securities market analysts examines this issue, no definitive conclusion either proving or disproving a causal linkage between non-commercial (investors) trading and large energy price swings over the past few years has been reached. – What drives crude oil prices? (2013)

The EIA goes on to state the main reason for the absence of a clear determination on a causal link between oil prices and investor money flows is this:

Because the vast majority of (oil) positions are held in the less transparent OTC derivatives market, however, analysis that relies only on readily available data from the transparent portion of the market may offer only limited insights. Additional data and analysis are needed to better understand the relationship between energy derivatives (investor) trading and price movements. In addition, the global nature of trade in energy-related derivatives adds to the challenges of analyzing trading activity.

In other words, the EIA doesn’t know if investors’ buying and selling oil actually influences oil’s market prices. But they acknowledge that investors are a new and important player in the oil market. They just don’t know how important we are.

Better safe than sorry

Leading up to 2012, gold investors were in the same predicament! They knew that they could buy gold directly through ETFs. After all, they were buying gold ETFs. But at the same time they refused to believe that investor money flowing into ETFs had a causal link to the actual price of gold. Gold investors chose to ignore money flows and to simply chant the gold story – government money printing causes inflation!

So, are oil investors caught in a similar state of denial? Will the future direction of oil also be subject to investor disenchantment as an investment, as we’ve witnessed with gold?

In other words, if investors begin to feel that oil’s story (i.e. Peak Oil’s diminishing supply meets growing demand from emerging economies) begins to erode, will they begin to sell their oil ETFs – just as gold investors did?

Three oil stories to watch

So, if we accept that investor demand is an important determinant of oil prices, we’ll need to watch for signs that oil’s story is eroding. Because once investors begin to lose confidence in oil’s story, money will begin to flow out of oil ETFs and oil’s market price could come under sustained downward pressure. And this, of course, will affect all of our wallets.

Here are three oil stories to keep an eye on:

  • The shale gas and oil boom: We have witnessed an amazing shift in the world oil market as a result of combining new “fracking” technology with horizontal drilling. This development has enabled the United States to become a net oil exporter (after decades as a net oil importer) in a few short years and it has created seismic shifts in the world’s oil markets. Particularly, investors should watch for the changes that result from this technology being deployed in other countries (China, Russia, etc.).
  • The lifting of the Iranian oil embargo: While a complete settlement is months away, if Iran can compromise and the international embargo on Iranian oil exports is lifted, the new oil supply will push oil prices down even further and oil price erosion will impact middle east policies.
  • The U.S. starts to export oil shortly: Shortly after the 1970s oil crisis, the U.S. passed legislation restricting oil exports and this legislation governed almost four decades as the U.S. needed to import oil to meet its growing needs. Today, there’s a lot of lobbying going on by U.S. oil companies to have the export restrictions lifted. If they are lifted, expect additional downward pressure on oil prices.

In the mean time, what you can do today

Because Canada is a major oil producing country, oil represents a big segment of our economy, our social fabric, our culture and our investments. Most Canadians have a portion of their savings invested in the oil industry – either through pension plans or their personally accumulated retirement savings. So discussing the future direction of oil prices is important.

If oil prices are influenced by investment demand and that demand begins to falter, then our investments could experience a similar drop in value as gold – down 37%.

So, now is a good time to review your investments to make sure your exposure to oil is not too heavy, and if it has been a long time since you last rebalanced (i.e. secured your oil profits), now might just be a good time to do so.

 

Read the 1st article in the series - Warning: is oil the new gold?

 

 

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