One of the biggest headlines in investment markets today is oil – its current price, what it means, how it will affect the economy and most importantly, where the next profit opportunity is!
Crude oil (CL1) has dropped from its dizzying high of $140 per barrel to a current $31.50 – a big enough move to make your nose bleed! This move is enormous, not simply from a price basis, but also in terms of the economic and trading opportunities it creates. The term “Once in a Generation” springs to mind, as it did 9 years ago, at the start of the Commodities boom super-cycle.
What has caused this enormous shift and what does it mean from a money making perspective?
With any price, it is a function of both supply and demand – where they meet (equilibrium, for the Economists) and that figure is $30.50 as I type.
Much has been made of the slowdown in the Global economy. China’s stock market imploding, easing growth and the World is about to cave in. Reality is, while China has slowed down, and with it, its major trading partners, the World has not caved in! In fact, demand for Crude Oil, has remained relatively stable.
Traditionally, as both an Economist and a Trader, I have always held the view that the risk with Crude Oil is always skewed toward supply, not demand. After all, demand for Oil is relatively inelastic – in plain English, not price sensitive (similar to alcohol, tobacco and pharmaceuticals).
Therefore, if demand has not shifted, at least materially, then the cause must be in supply! Production in Crude, depending on which statistics you consider, is currently around 80-90m barrels per day!
Crude Oil from the supply side
Traditionally, the Supply of Crude oil has been dominated (and continues to be) by OPEC members. However, recent years have seen some interest shifts in the relationships between members.
Then there are the non-OPEC members who are drawing oil out of the ground faster than could be believed. Russia, for example, is in a terrible economic state, its currency, the rouble has been decimated against the US$, down around 60%. As a result, US$ crude oil revenue is very much needed, even with Crude Oil at such low levels. Current production is estimated to be around 10m Barrels Per Day.
Iran has also re-entered the market, following years of diplomatic and economic isolation. Its return and additional production is not great news for OPEC, where more supply means lower prices. Not what Opec wants, but is a result of market forces.
At the hub of Opec are countries like Saudi Arabia. The drop in Crude Oil prices have had a significant impact on the Saudi economy. Areas such as tax hikes, subsidy reductions and higher unemployment are very real probability for the Oil rich kingdom. Additionally, Saudi Arabia has been chewing through its foreign currency reserves – to the tune of $105bn in 2015 alone.
Then there is US Shale Oil
The US Shale Oil revolution has been a massive game changer on so many fronts. US oil production has increased from 9% to 13% of the global production and helped shift the energy dependent economy to becoming a net exporter of oil. Aside from the obvious economic boom that has come from this (and now in areas such as Dakota, contraction) the geopolitical aspects of this are massive.
Relations with the Middle East are certainly different, with the US/Iran progress causing strain on the Saudi government, which has historically had unequivocal support from the US.
Attempts to keep oil prices lower may eventually cause the US Shale Oil industry and its above average production costs, to cave in or scale back, restoring the status quo of the US needing Middle Eastern Oil.
So who is benefiting from lower Crude Oil prices?
Some research I saw the other day from Merril Lynch suggested that as much as $3trn has been re-distributed from Oil Producers to consumers – a simply staggering number.
Looking more closely, lower oil prices provide a material difference for most households.
In the US, the average US household is around $1100 a year better off, based on lower fuel prices. That is equivalent to a universal tax cut and will almost certainly flow through into consumer spending, across a range of areas.
Equally, several industries such as Airlines, Transport and Distribution and packaging are also enjoying boom times with substantially lower costs. Take a look at the share price performance in the Airline industry to see what we mean.
However, on the other side of the ledger, outside of the Oil companies, governments too are suffering.
Most Governments rely on the very predictable receipts from tax on fuel. Higher fuel, higher tax, lower fuel, lower tax. In Australia, the Fuel levy is currently 38cents per litre. This is part of the reason why fuel prices are higher than the underlying crude move would suggest they should be. Equally, with GST at 10% on fuel, tax receipts at $1.20/litre are significantly more than at $0.85 a litre. This is a major issue for any Government that is hungry for tax receipts.
So where is the opportunity?
From an investors’ perspective, shorting oil companies would seem the obvious thing, although this requires a more specialist level of knowledge and skills than many investors have. Alternatively, shorting Crude Oil. This is a little cleaner, being a Futures contract and with a 1cent move in Crude being worth $10 to a futures trader, the 1000:1 leverage may seem very appealing, that is until you are on the wrong side of the trade!
We are currently trading an Exchange Traded Fund (ETF) which provides a leveraged exposure to Crude Oil and in particular the short side. We are then able to continue trading Covered Calls, to generate income from the position, as well as capital gain. This enable a lower risk adjusted return for clients, while capitalising on a major economic factor – that of crude oil.
Many people know about this, but having the knowledge and confidence to apply it – well that can be another matter. Why not let us help you with that?