Why Oil Prices that “Should” be Going Higher are Going Lower

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I once heard an oil man say that he who predicts the future price of oil lies, even when he is telling the truth. The market currently shows hydrocarbon energy prices declining in the future. Is the market lying or telling the truth? There is always room for debate.

Greater Stability Helps Long Term Planning

Global post-2008 financial reforms have yielded more stability in hydrocarbon derivative and physical markets. The Chicago Board Options Exchanges (CBOE) Oil Volatility index has dropped from a peak of 100 in 2008 to 20 in 2014. This 80% reduction in volatility primarily reflects the exit of speculators who now must post collateral to cover derivative trade positions. This in turn drives headline traders – who seek to profit from short term trading – out of the market leaving sellers and buyers – who must lock-in longer term energy profits and costs – to benefit from greater transparency and more accurate forecasts.

Does Current Backwardation Reflect Long Term Physical Market?

The current hydrocarbon derivative markets are largely in backwardation, meaning that oil, natural gas, and refined products sold for delivery in future months are less expensive than today’s price. While the current market benefits downstream crude users (refineries), it induces less upstream investment than a contango crude market in which the price of crude oil to be delivered in future months is higher than crude oil today.

More People Means More Energy Needed

A number of energy investors take a contrarian view to the current market. Bloomberg Markets Magazine recently said that noted energy investor Andrew John Hall believes that crude oil prices will increase steadily to “as much as $150 in five years or less.” Dan Dicker, author of “Oil’s Endless Bid”, recently stated on BloombergBusinessweek that oil could rise to $130. These investors believe that the world is growing in population, the rising middle class in many parts of the world consumes more energy, and hydrocarbon alternatives such as renewable fuels are not yet cost effective on a global scale.

What could make the price go higher?

Since its founding in 1960, the Organization of Petroleum Exporting Countries (OPEC) has heavily influenced the global price of oil. Geopolitical instability, notably in the mid-East, has occasioned the market to anticipate price spikes, and OPEC has reacted in many cases by increasing production quotas to bring the price back down. This phenomenon has allowed speculators to bid up the price of crude in reaction to political events, and then to cover those bets by buying lower priced crude in anticipation that OPEC would react by increasing supply.

The world has not seen a dramatic increase in crude prices in recent months, despite the increased violence and instability in Iraq, the Ukrainian conflict, or the Ebola outbreak in West Africa. Certainly new financial market regulations such as Dodd-Frank, Basel III, the European Markets Infrastructure Regulations (EMIR), and the US Federal Reserve’s push for banks to divest in physical commodities (https://www.enverus.com/oil-and-gas-prices-banks-puppet-master/) have reduced speculation.

Effect on Investment

While the price of energy may not reflect the true long-term demand curve nor the current geopolitical realities, long-term infrastructure investors have certainly taken note. The US Gulf Coast is enjoying the largest investment in Oil & Gas midstream and downstream since WWII. No doubt investors believe that political stability in the US will not be subject to the same tragic events that continue to take human life in the Middle East. In addition, investors in North American hydrocarbon assets are less likely to be concerned with political sanctions such as those currently levied against Russia.

Greater Stability = More Investment = Long Term Yield

Greater stability in global energy markets largely benefits buyers, sellers, and consumers. Investors who see an underpriced market today may profit tomorrow by buying a resource that has manifestly improved the quality of human life for the past 150 years.

Your Turn

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Tom Morgan

Tom Morgan is an Analyst for Drillinginfo. He has 20 years of experience practicing law with a focus on advocating for public policy to advance energy security and private property rights. Tom received his law degrees from Georgetown University and American University law schools. He hosts the weekly Drillinginfo Energy Minute, and you can find and connect with him on LinkedIn as Tom Morgan.