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Warning: is oil the new gold?

January 17, 2014 by Editor, InvestingForMe

Anyone watching oil prices right now has got to be asking his/herself the question, is the future of oil prices going to fall to the Dumber Guy Rule? That’s the investing rule that governs the market price of assets that don’t produce anything, don’t manufacture anything, don’t create any new technologies or processes, don’t create any revenue or profit, and don’t pay investors any interest or dividends. It’s the rule where you can’t value investments using the usual business and investment valuation models to determine current and future market prices. You know, the same rule that brought down the price of gold. Remember?

 

 

Gold’s story (quick recap)

For the past couple of years gold investors have been tortured watching the price of gold (and value of their investments) fall from its peak in 2011 of $1,900 to just over $1,200 today. (That’s a 37% drop – ouch!)

In a previous article (Gold: Should You or Shouldn’t you?), we outlined how the gold price is determined mainly by the amounts of money investors pour into investments like exchange-traded funds (ETFs) that invest directly in gold. By examining the investment demand for gold, it was easy to see how money-flows from investors influenced gold’s trading price – on the way up and now on the way down!

So, given the tale of gold prices and the Dumber Guy Rule, you got to wonder if oil prices are going to go the same way. Will oil investors be just like those investors that bought into the gold story (where they believed the story sold to them by the investment industry that gold prices were going to rise as central banks juiced financial markets with their money-printing, triggering a new wave of inflation!)? That’s the question!

Every investment needs a story!

It’s true. After all, when it comes to investment ideas, the investment pros understand they are selling a concept (not a good or service), and the best way to sell an idea is with a great story.

Oil investors have bought into the oil story (hook, line and sinker!). The oil story, for those of you not familiar with it, goes like this: 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). This diminishing-supply-vs.-growing-demand story helped the investment pros sell the concept of oil as an investment. And as with the gold story, the oil’s story sounds like a plausible, fact-based theory explaining the increase in oil’s market price over the past decade.

But maybe we should take a brief look at how the oil story really developed.

First, a little background

For more than 100 years the basic premise for buying and selling oil remained the same where buyers and sellers would make a legal agreement to take, or to make, delivery of a pre-specified quantity and quality of oil on a set date at set location. The agreement was always for the physical delivery of oil where the buyers had to physically receive barrels of oil and the sellers had to physically deliver barrels of oil. This simple physical-settlement characteristic pretty much meant that only producers and consumers traded in oil. In other words, investors and speculators who were not able to deliver or receive physical barrels of oil were pretty much left out of the oil market. However, all this began to change with the oil crises in the 1970s and when technical market innovations changed how oil was traded.

The 1970s transformed the industry forever. Oil trading based upon a physical delivery/settlement model enabled large oil producing countries to restrict oil shipments. The physical delivery/settlement meant producing countries could hold consuming countries hostage leading to two oil-price shocks and price volatility became a new feature of the market. This new volatility created the need for oil producers and consumers to hedge future oil prices, and in response oil traders created a short-term physical trading market for the buying and selling of oil.

New oil market: bigger, faster, better?

In 1980 the International Petroleum Exchange (IPE), now called the Intercontinental Exchange (ICE), created the first cash-settlement contract and from 1981 to 2001, oil traders were able to buy and sell oil without the risk of having to make physical delivery/settlement. As a result of this change from physical-settlement to cash-settlement and the eventual adoption of electronic trading in 2006, trading volume in oil skyrocketed. For example, NYMEX crude oil’s average daily trading volume was 107,579 contracts in 1988, 254,162 contracts in 1998 and 1,173,548 in 2008, with most of the jump coming after 2006, as a result of cash-settlement and electronic trading.

The following graph paints a better picture of what that staggering jump in oil trading in 2006 really looked like:

 

 

But the rapid expansion in oil trading is not just a result of the shift to cash-settlement and technical trading changes; it’s also a direct result of an increase in demand – both real and investor created.

In a 2008 testimony before the U.S. Senate, it was reported that between 2003 and 2008 investors’ trading in oil increased by 848 million barrels. According to the U.S. Department Of Energy, between 2003 and 2008, annual Chinese demand for petroleum increased from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. So investor demand for oil was almost equal to the increased demand from China.

Rising commodity prices: more investors

Oil is not alone in this surge in demand from investors. The switch to cash-settlement and electronic trading spread like wildfire to every other commodity (gold, copper, natural gas, etc.), and almost overnight demand from investors surged.

The chart below shows how investor demand for commodity ETFs strategies rose from $13 billion at the end of 2003 to $260 billion as of March 2008, and how prices for the 25 commodities that compose these indices increased by an average of 183% in those five years!

 

 

One particularly troubling aspect of investor demand for oil and other commodities (and the new cash-settlement system) is that demand actually increases the more prices increase. Rising prices attract more investors, whose tendency is to increase their buying as prices rise. So their profit-motivated demand for ETFs is the inverse of what you would expect from price-sensitive consumer behavior. (Sounds to me like the Dumber Guy Rule is alive and well!)

The chart below shows this dynamic at work in the overall commodities market. Note how as investor money pours into the markets, two things happen concurrently: the markets expand and prices rise.

 

 

Wow, right? So, with that new cash-settlement and electronic trading system, oil trading jumped, and still keeps on increasing!

But something else also happened in 2006 at this point. By creating a cash-settlement option for oil traders and shifting to an electronic trading platform, a whole new demand for oil was created – i.e. investors like you and me!

New possibilities for investing: new advice to diversify

Prior to 2006 there was no convenient and easy method for the average investor to invest savings directly in oil – or any commodity for that matter. In fact, 2006 not only marks the year oil began trading electronically, it also marks the year the first ETFs were created for the sole purpose of investing in commodities – oil, gold, wheat, sliver, etc. Prior to this, investors could buy mutual funds that invested in companies that operated within the oil industry, but we couldn’t invest directly in the price movements for oil itself.

From 2006 onward, as the number of commodity ETFs expanded, investors were told by the investment industry they must diversify their investments. No longer was it acceptable to only own stocks and bonds when you could invest your savings directly in things like oil, natural gas, copper, silver, gold, wheat, pork belly, orange juice, etc. Investment diversification became the call to action for investors to start buying oil ETFs. And buy we did!

So, what’s going to happen with all of us buying so much oil? Well, if the history of investing in gold can teach us anything, maybe we all need to sit up and take note. 

We’ll take a look at that can of worms in our next article.

 

Read the next article in the series - Oil’s market price today: where do you want to sit as an investor? 

 

 

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