Fundamentals Of Crude Oil Pricing: Part I

Without a doubt, crude oil has been the commodity with the most buzz surrounding it over the last three years. Every investor and analyst (especially those geniuses on CNBC) have an explanation for every single move, but more often than not they are either misinformed or lying. The importance of crude oil to our world financial markets is very important, it affects everything from companies transportation costs to consumer behavior and spending habits. Being able to predict the future price or price movements would be an invaluable skill, but the question is how would an investor even go about this? I believe the basis of this unattainable skill is influenced by a wide number of factors.

After I realized that this article was quickly turning into a book and then into an encyclopedia, I thought the title may be somewhat misleading. After some more thought, I decided to break up this post into a Five Part series. On top of that, the concepts I have presented are not very in depth, but they take time and a lot of writing to put into context. Without a general understanding of these concepts that I am about to delve into, you will not be able to fully grasp the scope of the larger concept.

Crude oil has one of the most complex and variable pricing mechanisms in the commodities market. It is even more complex than almost every other liquid asset class. Crude oil pricing is affected by a host of different factors, and it can be extremely difficult to determine which factors have the greatest impact on the actual spot price at any given point in time. As you have certainly seen in recent months, the crude oil markets have been extremely volatile and it is possible to make or lose a large sum of money very quickly. Many investors believe that the crude oil markets are susceptible to heavy manipulation, but when attempting to present evidence, their thesis generally comes up short. A good example of this would be that these “speculators” have been net short crude oil from early March 2008. During this time period, crude actually appreciated from the $110-$120 range all the way up to $147 even though there were heavy bets against the commodity. While I don’t believe that manipulation drives oil markets, I am not saying that manipulation doesn’t take place. Instead I would like to focus on other factors that have been affecting crude recently:

• Fundamentals of Supply and Demand
• OPEC
• Russia
• Shortages, Stockpiles, and Decline Rates
• Discoveries
• Currency
• Refiners and the Crack Spread
• Geo-political Tensions
• Weather Threats
• Fear and Uncertainty
• Other Risks

Hopefully I can shed some light on these factors as I will be the first person to tell you that I am not a sooth-sayer. I can tell you for certain that anyone who has a prediction for the price of crude in the short term shouldn’t be taken seriously because of their arrogance and lack of intelligence on how crude oil has historically traded in terms of volatility. While I believe no one can predict short term movements, I do believe that with a strong understanding of macro economic factors as well as supply and demand it is possible to formulate a reliable general prediction for where crude oil will be trading far out into the future, somewhere in the range of 5 years and beyond. General stock market news in general can also have an effect, but I would rather explore some of the deeper points.

Fundamentals of Supply and Demand

The most basic metric for crude pricing is the simple fundamentals behind world wide supply and demand. Obviously these two factors are not exactly known down to the barrel, but it is widely accepted that crude oil supply is around 85 million barrels per day (Mbpd) and demand is around 86.5 Mbpd. However, during the current crunch many experts believe that worldwide demand has dropped due to the severe economic slowdown that is looming upon us and about to occur starting next quarter. With a basic understanding of economics you can understand that this discrepancy must be filled through a market clearing price. This market clearing price occurs whenever approximately 1.65 Mbpd of demand is “priced out of the market.” This single value is the basis for crude oil pricing but by no means is the only factor. Supply and demand may be the most important factor because all of the other factors can have a direct impact on supply and demand on a daily, monthly, or yearly basis. Supply and demand is the metric that investors always will go by whenever they are interested in long term horizons, basically any time period from 5 years to 30+ years.

Disclosure: COP owns a stake in LUKOIL and the mutual fund the author manages as well as the author’s family is long COP. The author’s family is also long PBR.

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