Divergences In the Oil Patch Lead To Opportunity

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Commodities are some of the most volatile assets that trade. When it comes to raw material markets, prices move for a number of reasons. Fundamentals, or supply and demand characteristics, can highlight whether a particular commodity is in over supply or in deficit. Technical factors, chart patterns, will yield important clues as to the behavior of market participants. Demographics affect prices. Weather events often play a huge role in price direction.

Politics, on both a domestic and international basis, can move prices. There is so much to consider when evaluating commodity markets.

Crude oil is perhaps the most political as well as the most widely consumed commodity on planet earth. The price of crude oil affects many, if not all other asset classes. There are myriad of factors to consider when evaluating the price path of crude oil. Simply looking at the current price alone is insufficient when it comes to making educated and wise investment decisions. Therefore, there are a number of different pieces to consider when solving the puzzle for the price of crude oil.

Inventory data

A good place to begin your analysis is with a fundamental understanding of supplies. The United States Energy Information Administration (EIA) and the American Petroleum Institute (API) publish data on crude oil inventories on a weekly basis. Each agency approaches the crude oil market from a different perspective.

The EIA is a U.S. government-funded agency. The API is an industry-based organization. The inventory data provided by each is an important starting point for understanding the current supply and demand equation for the crude oil market.

Quality and location spread

There are two benchmark-pricing mechanisms for crude oil in the world markets.

West Texas Intermediate (WTI) is the benchmark price for North American crude oil. WTI futures contracts trade on the New York Mercantile Exchange (NYMEX) division of the Chicago Mercantile Exchange (CME). WTI is a low sulfur crude oil that is generally easier to refine into oil products like gasoline.  Brent North Sea crude oil (Brent) futures trade on the Intercontinental Exchange (ICE). Brent crude is light and has relatively low sulfur content; it contains slightly more sulfur than WTI. Brent is generally more appropriate for the production of heating oil and diesel fuels. Brent crude oil is the benchmark pricing mechanism for crude oils produced in Europe, Africa, and the Middle East.

The price differential between WTI and Brent crude oil is both a location and a quality spread. Monitoring the price differential and movements between these two crudes will highlight supply and demand differences between the two oils. They can often provide clues as to important issues affecting the overall price of crude oil and its future price path.

Term structure

Term structure is another important thing to consider when analyzing the price of crude oil. Term structure is synonymous with calendar spreads, intra-commodity spreads or time spreads.

Term structure in crude oil measures the price of the commodity at different times in the future. If nearby prices are higher than deferred prices, a condition of backwardation exists. Backwardation signifies a supply shortage or tightness in the market. When nearby prices are lower than deferred prices, a condition of contango exists. Contango signifies either a market that is in oversupply or where supply and demand are balanced and equilibrium exists.

Term structure provides important clues as to the supply and demand equation in both Brent and WTI crude oils.

Processing spreads

Processing spreads measure the economics of processing one commodity (in this case crude oil) into other commodities (oil products). Crack spreads are processing spreads that reflect the economics of refining crude oil into gasoline and heating oil.

Crack spreads for gasoline and heating oil trade on the NYMEX division of the CME as standalone contracts. There are also crack spreads in terms of refining crude oil into jet fuel, naphtha, gasohol and other oil products. These crack spreads trade in the over-the-counter market. Consumers do not buy raw crude oil they require oil products. Therefore, the price and volatility of oil products offer important supply and demand data as to the future path of crude oil prices.

The bottom line is that in order to understand the price of crude oil and properly analyze the future path of the commodity there are many factors to consider. Monitoring these factors will uncover divergences from historical norms that occur. These situations present investors and traders with some of the best opportunities to make money and understand if the price of oil will rise or fall.