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Where is oil headed?

By beled | March 19, 2015

David Leslie, a director of Belmont Asset Management, takes a closer look at the headline-grabbing decline in the oil price since mid-2014:

David comments, ‘In order to decide whether the oil price (and most other commodity prices) are in an unsustainable price range, we need to consider several important factors.

‘Firstly, very few economists see medium-term equilibrium crude prices below U$80/barrel unless there is a global economic depression such as in the 1930s. Then there is also the fact that, contrary to popular wisdom, a lower oil price is not necessarily good for the global economy. This is because an equal amount of revenue is removed from the oil producers who are also consumers and investors on the international stage.

‘There is something else to consider. Energy contracts are highly leveraged products. One NYMEX futures contract for crude oil represents 1000 barrels of crude. The dollar value of this contract is 1000 times the market price for one barrel of crude, for example if the market is trading at $60/barrel, the value of the contract is $60 000. Based on NYMEX margin rules, the margin required to control one contract is only about $4 000. So for $4 000 one can control $60 000 worth of crude – a leverage ratio of 15:1.’

David adds, ‘Further, crude oil accounts for 40% of the world’s energy supply, and is the most actively traded commodity contract worldwide. Crude is the base material that makes diesel, jet fuels and thousands of other petrochemicals. And consider, too that there are large stocks of oil either in onshore inventories or on the high seas in supertankers. Because these inventories can dwarf the daily flow of oil traded through the spot market, they can dramatically increase price volatility in the short-term.’

Because of the huge leverage imparted by margining (which is effectively a form of borrowing), futures contracts are extremely sensitive to interest rates and price expectations of the underlying commodity. As a corollary, a self-reinforcing cycle of bull or bear sentiment can rapidly emerge. Under such conditions, short-term price trends tend to have a parabolic shape when charted, i.e. display “bubble” behaviour whether upwards or downwards.

David concludes, ‘Bearing in mind the above, we believe that the decline of spot oil prices has been severely aggravated by a futures-reinforced cycle of negativity.  Based on this analysis, we conclude that oil prices are in an extreme area and accordingly unsustainably low.’

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