Oil Story

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Perhaps this week the market can take a rest from the volatility that circles our world. What is interesting is the market (fueled by our media) acts surprised by these volatile events, when in reality they are all fairly well known and we should have a level of probable expectations. This is what concerns me about the VIX pricing, which seems low in relation to the probability of volatile vents. That’s perhaps why we see the VIX over-react in jerks and fits playing catch-up.


Oil Story

In the last decade the oil story has played out in interesting fashion. From price shocks (high and low), fracking, Middle East unrest, Keystone Pipeline, just to name a few. While we all love talking about alternative and renewable energies, we and the world are still deeply married and dependent on oil and not just for gas.

Oil Price
Oil prices are currently looking to snap below $40 a barrel, certainly a shock (to the downside) if we look back just a year ago. We need to be careful when we try to speculate about oil price (or for that matter commodity future pricing). It is far too easy to make the assumption that there is MORE oil and we are using LESS, by applying in very broad terms the Law of Supply & Demand. However, oil prices are far more complicated than just simple supply & demand assumptions.

Futures:
Oil price is derived and driven by futures contracts, which is an interesting animal. A future contract, be it oil, gold, corn or even financial futures (S&P 500) do NOT exist until a buyer and seller come together. Unlike Stock, which has a discrete and measurable amount of shares, in the futures world you can create far more contracts than there is actual oil to be delivered. You can freely sell (short) futures without having shares like stock, which handcuffs and limits a stock seller (short). While it is true, by selling futures (short), you promise to deliver (in the “future”) the commodity – you can always buy back your future contract or buy the commodity for delivery in the future. The point is you don’t have to own oil to sell it in the futures market. Thus in the futures world, you can sell as much as you want – as long as you have money or margin. This distinct difference in how futures work vs. equities (stock), which can allows for significant price volatility.

This interesting mechanic that differentiates futures means that the SUPPLY of oil can theatrically be unlimited, regardless of how much actual oil there is. This means that oil prices are NOT driven by the actual Supply & Demand of physical oil, but rather the Supply & Demand of those participating in the oil futures market, where an INFINITE supply can be created out of thin air. If you had enough money (margin) and balls – you could drive oil prices to $10 or $100, without ever owning or even plan on buying/selling physical oil.


Physical oil Supply / Demand
Two common and often mischaracterizations of oil demand is to myopically focus on the U.S. demand and measuring cyclical demand, short-trends (month-to-month).
First, the U.S. is not the only nation on the planet that consumes oil and we are not even the largest or fastest growing. Additionally, the oil consumption in the summer vs. winter changes and that short-term change is cyclical and should not be consider a trend for annual year-over-year demand.

Oil Production
The advent of fracking (oil shale and sand) has tapped a new reserve that was once unthinkable. It has increased production in this nation to meet demand. Oil production in the U.S. fell from its peak of 11 million barrels per day (mb/d) in 1970 to 6.5 mb/d by 2009. Today, since the first fracking, oil production in the U.S. is over 10 mb/d.

According to the International Energy Agency’s (IEA) latest report; world oil production 96.4 mb/d (2nd quarter 2015). As a comparable, it was 90.7 mb/d in 2012.

Oil Demand (consumption)

The IEA’s world oil consumption report has increased from 90.7 (mb/d) average for 2012 to 94.22 mb/d for the 2015 average. The over average year-over-year growth rate (decade) has been .5 mb/d, but the rate is also increasing and now we are up to 1.4 mb/d. This trend will continue, 2016 is expected to be at 96 mb/d, and increase of 1.7 mb/d.

It is true, from time to time, the U.S. oil consumption falls, but that doesn’t mean the WORLD’S consumption falls. The largest nations (by population) are seeing double digit oil consumption growth over the last decade and that doesn’t look to change for the next decade.

It is certainly true that global growth has slowed in the last year, with much of the focus on China’s slow-down, what we can’t forget is that it is still GROWING. The math is simple, more oil will be consumed at a faster rate each and every year around the world.


Actual Supply vs. Demand Rate
Currently we are producing an extra 1.8 mb/d (Supply / Demand). This spread in supply vs. demand will certainly allow some stockpiling and some in the media have used the word “glut”. However, that doesn’t even amount to 1 day’s oil consumption if we saved the stock pile for one year. Current stock piles would last 1 – 3 months(depending on nation).

Dollar value impact
The Dollar has rallied (broad dollar index) over 24% in the last year. Oil has declined 50% over the same period. Oil is priced and traded in dollars, so the dollar rally has certainly impacted the price of oil. That certainly explains oil falling from the $90 range down to the mid $60s. If the dollar continues to rally, oil prices will continue to fall. It is just math that has nothing to do with supply and demand.


OPEC conspiracy


Courtesy of wikipedia

One common conspiracy that has circulated, even among mainstream media, is that OPEC is forcing prices lower to make U.S. fracking production less profitable.

Accusations have range from increasing production to actually selling in the markets. I don’t see it as much of a conspiracy, it is just basic business practices. You want to drive competition out of business, you drive down prices in which they can’t compete. Sure we might not like it, but it’s a free market (or is it)?

Fracking costs considerably more than traditional oil production and at this mid $40s level per barrel, some have stated that fracking is barely breaking even or losing money.

Of course low prices also hurt OPEC nations as well. They get less money per barrel and the strong dollar is also creating inflation in those nations.


Dollar

The oil story weaves into the U.S. dollar story. When the U.S. came off the gold standard our nation created the unofficial “petro-dollar” relationship. This was an agreement in which OPEC and other oil member nations would price and trade oil in U.S. dollars in exchange for security. This agreement help stabilize the dollar when it came off the gold standard, as it forced nations around the world to use dollars to obtain oil. It also help fuel U.S. bond purchases by many foreign nations, to protect them from inflation – as they would need dollars to purchase oil. Why not get paid interest for holding dollars that they would need. It was a win-win for the U.S., helping secure it as a world reserve currency after the gold standard ended and also help monetize government deficit spending – as foreign nations bought our bonds (to secure their dollars).

The question now is now long will the dollar maintain this petro-dollar relationship. OPEC is certainly not happy about the strong dollar and the low oil prices (whether partly a coordinated OPEC plan) is certainly hurting their revenue. The Iran Deal, ISIS, Syria, and a host of volatile issues are also creating some uncertainty as to U.S.’s commitment to this “petro-dollar” relationship.


Fed

The Fed’s decision in September as to whether to raise rates will have a direct impact on oil and also OPEC. The Fed’s radical monetary policies are having massive and penetrating impacts to world trade, currencies, and oil prices.

We can’t ignore how the Fed’s policies have huge ripple effects around the world. The U.S. and the world has become ever more connected to the Fed’s monetary policies, interest rates, and bond fixing, whether they like it or not.


Support & Resistance

INDU 17,400
the Dow Jones is still flirting with that 17,400 level and could just as easily break down below it again. The question remains how we close and if buyers are willing to step into the market.

NDX 4500
The tech heavy index is holding above that 4500 level, but a crack down to 4450 is certainly a possibility .Expect volatility.

SPX 2080
It seems that 2080 is going to be a testing support area. While not as weak looking as the Dow Jones, I think we could see some volatility down to 2070 before we see bounces. The real low support is 2050. For now watch the close to see if we can close at 2080.

RUT 1200
For me it all comes down to the Russell index and if money is flowing into the markets or out. I would watch the 1200 level as support, if the Russel has strength we could see the short-term volatility in the narrower indices calm down.


The VIX has been underprices and playing catch-up only AFTER the indices make their big daily moves. This morning (before the open) it is in the 12 range and in this market that is a WARNING sign that the market is far too complacent. Insurance is cheap and the risk premium should be in the high teens to say the least.

Watch the markets and how they close. The dollar is now driving broad market conditions and the Federal Reserve has their finger on the interest rate button. I stand by my belief the Fed will NOT raise rates, primarily because they can’t at this point – without causing ripples across the currency and commodity markets, that will trigger equity selling pressure.

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