Find out What Is Really Controlling Oil Prices

What Is Really Moving Oil Prices?

Traders in The Oil Pit
Oil Traders in the Pit. Ramin Talaie

As I have explained in the past, such as in this video, the price of oil is not dictated by supply and demand as everyone else is going to tell you. It is controlled by a room full of traders in London, and a room full of traders in Manhattan, none of which has ever seen an actual barrel of oil.

Do yourself a favor - go back and read that last line again.  That is why when there is a slight surprise in terms of oil draws, or a tiny revision to supplies of only a fraction of a percent or two to the world's total oil, you can often see a move in the price of 10, 20, or 30% or more.

 

Yes, of course those traders in Manhattan and London are making their speculative investment decisions based on actual fundamental factors, but it is the speculative supply and demand which controls the prices and the trading activity, not the literal supply and demand.

After all, considering that the world will run dry by 2068, prices should already be reaching closer to $200 per barrel.  Of course, that's not according to me - that's according to British Petroleum (BP), the United Nations (UN), and the International Energy Agency (IEA). 

In other words, if there is a strike in oil workers in Nigeria that is expected to affect 1% of the world's oil production, traders will position themselves for what could potentially be higher prices as a result of the work confrontation. If that positioning gets to be too aggressive, you often see the effects on the price of oil of much more than the single percent which is affected (and in some cases the volatility can reach ridiculously significant and unjustified amounts).

In fact, it has been a long time since oil prices were moved as they should be by supply and demand. Rather, oil prices are moved by the potential effects of events which could affect supply and demand, and by extension induces speculators to jump in front of that with their trades.

The end result is that the price of oil often moves dramatically more than it should, whether up or down.

This explains a lot of the activity we've seen over the last few months, which sees the price of oil moving by 4% or 5% in a single day, even when the events which may affect the supplies and demands for crude oil have much less of an effect than that amount.

Much of the volatility in the speculation of oil prices is exacerbated by the fact that most investors are trading contracts and pieces of paper which allow them access to a certain amount of actual crude oil. The fact of the matter is that these traders have never seen a barrel of oil (and don't really care to at any rate).

There is a tremendous amount of leverage in oil, where each barrel can be traded ed by, or owned by, nearly 100 different people. In fact, the number of contracts which can be written upon oil trades is unlimited, and almost always will exceed the literal amount of actual underlying oil being traded.

So what can you do as a trader, given this oversized volatility in oil prices? Well, the first thing is to not read too deeply into any one event or data point.

When there is an unexpected draw on US oil inventories, the price may shoot much higher. However, that does not mean that the gain is realistically in line with the surprise in oil draw, but rather that it instigates many traders to take action and position themselves to try to benefit from the surprise in draw.

For these reasons, you should almost always ignore the volatility in oil prices over the short term. Keep an eye to the longer-term trends for oil.

For example, if you believe as I do that the globe is about to enter a significant correction or recession, then the demand and usage for oil will decrease significantly, resulting in lower prices. On the other hand, if you believe that the economy is going to keep on expanding and growing, such as it may considering that the developing nations are ballooning in population and energy use, then you can expect that the demands for oil will continue to increase, and by extension the prices will rise.

In general, not just with oil but with anything, you should ignore the reactionary reporting of the mass media. They're not telling you what is going to happen, they're just talking about what has already happened.

While we do not and never will give trading advice, and we do not know what's best for you or anyone to do, in my opinion I would suggest that there are plenty of ways to play the oil trade. For example, when oil spikes 10 or 20% in price on transient or temporary effects, or events which will not increase demand or reduce supply by 20%, then there may be an opportunity to make a trade when it appears that that 20% move has been significantly overdone.

This is not unlike trading in just about any commodity, such as some of the opportunities we've seen with gold. A lot of investors now trade through ETF's, but when they are trading hard commodities such as gold or platinum or oil, but they do it through an ETF, many times they are purchasing a piece of paper which gives them the right to take ownership of the barrel or ounce of the underlying commodity.

Talking about gold specifically, since so many people are buying ETF's such as GLD, they are leveraging or overselling how many ounces of gold are available. In some cases, there could be as many as 700 people who have a claim to the same single bar of gold, but none of them actually own the bar.

Said another way, the most effective way to play the oil trade may be to position yourself with the macro trends in mind, and ignore all the short-term fluctuations in price. If the global economy is going to grow, and the demand for oil will increase, then positioning yourself to benefit from increases in prices of oil may be prudent.

On the other hand, as economies all over the world, including in Asia, Europe, and South America, continue to slow down, we may be seeing a reduction in the demand for oil. This implies that prices will decrease over time.

Another consideration too, is that oil is often traded in US dollars. This means that another factor which affects oil prices is shifts or changes in the value of the US dollar.

For example, when the US dollar increases in value it will appear as though things which are bought in US dollars are decreasing in price, such as gold or oil or cotton. And when the US dollar drops in value in comparison to other currencies and also in comparison to the commodities themselves, it will take more dollars to buy the same commodity which results in an appearance of the actual commodity increasing in price.

One way to tell when a bull market is started in a commodity is to see when it detaches from the typical relationship to the dollar, like we just saw with gold.  For example, we saw gold detach itself from the effect of the US dollar, whereby it increased in price even when the US dollar was increasing in value.

This represented a diversion from the historical norms, and demonstrates that for now gold will trade on its own, regardless of how the American dollar does. This is a very bullish indicator for the metal.

Long-term, we have a very high outlook for oil prices. Specifically, we are looking for a single barrel of oil to cost well over $120 per barrel in terms of US dollars, especially considering that we have almost already run out, as I explain in this video, and also through OilClock.com, which everyone should add to their web site or blog to help raise awareness.

However, in the short and medium term, we are expecting oil prices to drop into the $30-$40 per barrel range. This will be especially true, and almost certainty, if we do enter a significant global recession as we have been expecting.