The Most Important Fact To Know About Oil Investing

Date Friday, September 5th, 2008

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.

Leave a Reply