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The Most Important Fact To Know About Oil Investing

by: Graham Summers September 04, 2008    

Graham Summers

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The most important thing to know about oil investing is this: No one knows where oil is heading.

Only four months ago (May ’08), oil cleared $120 a barrel on its way to $145. Within a month, analysts were calling for $150, even $200 oil. Countless graphs and charts surfaced showing how demand was outpacing supplies. Pundit after pundit commented that emerging markets like China and India were fueling an unstoppable mega-boom for black gold.

Then Russia invaded Georgia, and oil took a nose dive falling more than 20 consecutive days from $145 down to $115 a barrel. Hurricane Gustav gave it a brief shot in the arm, but the damage was less than expected and oil rolled over the next day.

Now analysts are predicting oil will fall to $100 or even $85 a barrel. Again the charts and graphs are surfacing, this time showing that both international and domestic demand for oil is slowing down. Phrases like “decreased US demand” and “global recession” are being tossed around, just like “emerging market demand” and “ChIndia” were being hurled a few months ago.

So is oil going to go up or down?

The honest answer is that no one has a clue. We can talk all we want about worldwide supplies, Brazil’s latest discoveries, potential drilling in the US and other factors. But the reality is that an enormous slew of conflicting issues affect oil prices today. Among the more glaring are:

  1. Geopolitical Issues (Israel vs. Iran) (Russia vs. Georgia/ the West).

    In the last three months, Israel has begun running test bombing campaigns to areas that are the same distance from Israel as Iran. Similarly, the US has sent three battle cruisers to the Persian Gulf. Should either of these countries actually bomb Iran, oil is going through the roof.

    Then there’s the situation with Russia, which is quickly turning into Cold War II. Reports are showing Russian bombers flying over Northern Europe, the Kremlin threatening to supply Iran with missile defense systems, and Vladimir Putin threatening outright confrontation with the West in the Black Sea. Should Russia and the West seriously go head-to-head, the Kremlin could turn off the oil tap, pushing prices into the stratosphere. Russia’s already turned off energy supplies once in the recent past: See Ukraine 2006. 

  2. Speculation

    Whether you believe in the “evil” speculator stereotype or not, the commodities markets are dominated by a handful of players. The Commodities Futures Trading Commission recently discovered that just four swap dealers — like commodity brokers — controlled one third of all long oil contracts in July. At one point, one particular trader accounted for an incredible 11% of the oil trading market. These kinds of heavy bets are what wipe out huge amounts of capital in an instant (think the Amaranth hedge fund and its $6 billion in losses from natural gas futures). Small surprise oil is making such large choppy moves day to day.

  3. The Over-Leveraged Financial System

    Institutional trading models and systems are dominated by linear relationships (euro vs. dollar, dollar vs. commodities, commodities vs. equities). There are literally thousands of traders following these patterns. When one of their models is triggered all of these guys pile into or out of a given investment. You can see this on a day-to-day basis. Typically, whenever oil rises, stocks plunge and vice versa (yesterday’s action when oil AND stocks fell is truly worrisome).

    Throw in a lot of leverage — investing with borrowed money — and you’ve got herds of guys who will dump a position if it even looks like it’s going against them. Just look at the action of the last two months where stocks rallied 1+% in one day only to give up all of those gains and then some the next. Almost every time oil was on the other side of that trade, rising when stocks fell and vice versa.

All of these factors collide in the oil markets. And they make forecasting oil’s moves virtually impossible. Could oil go to $80? Sure. But one bomb in Iran and it’ll be over $150 in a matter of days.

Similarly, oil could rise to $130 on concerns of a conflict between Russia and the West, only to plunge when an Amaranth-sized hedge funds blows up and has to liquidate its portfolio in a matter of moments.

Beware anyone who has a “certain” opinion on oil. When it comes to investing in black gold today, only one thing is certain: You need to be very nimble OR have a very high pain threshold. The oil markets have no sympathy for opinions, no matter how informed they are.

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This article has 12 comments:

  •  
    Sep 04 02:20 PM
    Good article. I'm watching the markets drop now so I have nothing else to say.
    Reply
  •  
    Sep 04 02:27 PM
    Very, very concerning and true. Thanks for the post.
    Reply
  •  
    Sep 04 03:20 PM
    Great article! Just one correction:

    'The oil markets have no sympathy for opinions, no matter how informed they are.'

    All markets have not sympathy for opinions. Oil is not an exception.
    Reply
  •  
    Sep 04 04:18 PM
    Nice article, it's good to hear common sensical writings that make for a more realistic bigger picture. Thanks.
    Reply
  •  
    Sep 04 05:30 PM
    Common sense can help a little bit. When oil was $140 and everyone was saying it was because of supply and demand, you had to ask yourself: Did demand double in the last 10 mos? Did supply get cut in half? Are all the momentum players in the market? Are people saying "it's different now?" Are experts predicting triple the price a year from now?

    On the basis of those non-technical, non-expert, totally uninformed observations, I bought DTO - in late to mid July $10 below the peak. I'm not bragging, just saying to consider all information and use your own judgement. A lot of the time you can beat the quant funds, momentum traders, and "linear models." Run for your life when everyone tells you an investment is a sure thing.
    Reply
  •  
    Sep 04 07:54 PM
    "The most important thing to know about oil investing is this: No one knows where oil is heading."

    Best line ever.

    oilismastery.blogspot..../
    Reply
  •  
    Sep 04 10:57 PM
    Very good article, very refreshing.
    Reply
  •  
    Sep 05 08:16 AM
    The marginal buyers and sellers matter - as in any market. And their motives and actions are almost unpredictable. So the author is absolutely right. However, i would add a second line to it: longterm oil supplies are going to get lower until they almost disappear and prices will reflect that. At one point oil will get only used for absolutely those purposes, where it cannot be replaced by any other matter. And no: driving heating, electricity generation do NOT belong to those puproses.
    Reply
  •  
    Sep 05 08:29 AM
    Thanks for your lucid and brutally honest assessment of this particular market. Your comments make a lot more sense than all the "self appointed" gurus who spout their "wisdom" via posts on this site. But is is not just oil that your comments apply to! Your assessment pretty much applies to much of the equity market since there is so much leverage and quant trading that now takes place and the small retail trader (or investor) is pretty much simply gambling at this point but without the benefit of knowing what cards have already been dealt.

    Even the legendary Boone Pickens really can't predict this market but at least he is big enough (and humble) to admit when he made a mistake as in his call this spring.

    Good show!
    Reply
  •  
    Sep 05 02:54 PM
    Thought: If no one can predict any market (although some can be lucky for long periods at a time), why do any of us listen to any of the analysts?
    Reply
  •  
    Sep 05 03:15 PM
    This is nihilism at its finest. We don't have to know with certainty to get the idea that the general direction is up. And we don't have to predict a date certain for a peak in production to get the idea that there's is likely to be a peak sometime soon.

    A year ago when oil was trading in the '70s, Boone said it would go over $80 dollars by his 80th birthday (this July, IIRC). Would we be so sanguine about the current price if the recent two-month price spike hadn't happened (only 4 days / $140)?

    The current oil price, in real dollars matches the high triggered by the loss of 3.5 mb/d of Iranian production during the Iran-Iraq war. What is going on now in the markets that in any way equates to that event?

    Given the record share of production controlled by govts and nat'l oil companies, state secrecy by the two largest producers, and rising mercantilism, high price volatility is expected.

    We are in a business-as-usual environment with record oil prices. That alone should and does indicate the future price.
    Reply
  •  
    Sep 06 03:38 PM
    If T. Boone Pickens suffered a 20 percent loss in his investment portfolio lately, which it seems he did on some elements in the portfolio, then no one does know where oil is headed.

    Reply
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