Before I get started on today’s post, I wanted to mention some great feedback I received from a reader recently. This person mentioned that, although the information on my post is extremely insightful and great for anyone to read, the style of the writing can sometimes come off as a little difficult to read. As I’ve said since day 1, I value any feedback I can get for my blog. After all, the whole point of it is to make readers more aware of the investing world and relate the major events in the investing world to real-world impacts. I’d like to thank that person (You should know who you are J) and invite everyone to offer any sort of feedback, whether it be for writing style, topics, structure, anything at all. I’ll try to incorporate the feedback as best possible.
With that said, let’s go on to the conclusion for the Oil Industry….
With the last post, we learned the details of the oil industry and how it works. Forgive me for sounding like a textbook in that post, but I feel that it’s important for people to know about the industries they’re investing in. Much of what I mentioned during the post should be known by anyone buying an oil stock. Like Cramer says on ‘Mad Money’, do your homework! If you don’t understand the company you’re investing in, then it’s nothing more than gambling. Before I give my opinions on any industry, I want to make sure that people understand where I’m coming from, thereby making sure that people understand where the opinion is coming from.
We learned that the price of oil, and the corresponding fuels created from it, is largely determined by investors and traders on the futures markets. These investors take their own as well as their clients’ money, along with their understanding of the oil industry, and buy and sell futures contracts for the sole purpose of making money. There’s nothing really that special about oil in that sense. They do this with all types of commodities. But, the price that oil is trading at directly affects the price you pay at the pump. Until the summer of last year, the price of oil had gone on an unprecedented rise. A barrel of oil (the unit in which oil trades which equals about 42 gallons) rose to almost $150. This was well beyond its historical norms between $20-$40 a barrel. This resulted in a price rise at the pump, as I’m sure most of you already know, of almost $4 a gallon for regular unleaded.
Now, I really feel that there are many reasons for the rise – some justifiable, others questionable. The justifiable reasons were driven by a fundamental demand scenario – the emerging markets like
You might then ask why would oil rise to $150 when the fundamentals only said $70. Well, let’s go back to the concept of the investors playing a big part in determining the final price of oil. Many of these investors are banks and hedge funds (money managers who invest billions of dollars for very rich people using extremely sophisticated investing strategies). Remember when we talked about how banks worked and the ‘L’’s – leverage and liquidity? Well, the huge amounts of leverage and liquidity available to these banks had other impacts than just housing investments. The financial instituations poured billions upon billions of dollars into the commodities markets as well. They were able to buy futures contracts at higher prices than the fundamentals dictated knowing that someone else would probably come along and buy it at an even higher price. They could ride the upward momentum in price as long as possible and still make money through it. The amount of cash the investors had caused an artificial increase in demand for the oil futures, but not necessarily for the oil itself. This demand caused a surge in prices which proliferated through the energy complex resulting in higher gas and energy prices for everyone. There was also very little decrease in the demand for energy despite the increase in prices, consumers just coughed up the extra cash to put gas in their SUV’s since even they had fairly easy access to liquidity through the housing boom. The prices acted like a ‘tax’ to the consumers that, for several years, were willing to pay.
Other than the investors, other beneficiaries of the higher oil prices were, of course, the energy companies. Due to the higher prices, the profit margins for these companies grew dramatically, making the industry one of the most profitable in the world. Also, the countries from which the oil came from became vastly richer. Of the $150 for the barrel of oil, a large proportion (my guess would be 30%+) went to the country from which the oil came from. As oil tycoon turned renewable energy promoter T. Boone Pickens said, this resulted in the largest transfer of wealth from one region of the world to another (the middle east where most oil comes from) in the history of mankind.
After the boom years were over, and banks began to lose all that capital they were able to raise, there was going to be a natural decrease in oil futures prices. This, coupled with the natural decrease in demand that comes from any recession, has caused oil prices to drop dramatically to their current level of about $35 a barrel. However, don’t get too comfortable with these prices. I still believe those futures traders have a big part to play here as well. Like I said, fundamentally, I feel that prices should be around $70/barrel in the long term. But because these investors lost so much money in other areas, they have been forced to liquidate in previously profitable areas – namely oil – to cover capital positions. Futures contracts have been glutted into the market with sheer lack of demand, causing artificially low prices.
Bottom line, once the banks stabilize and investors come back into the market in full force and more cash, I can see oil easily going back to $50-60 a barrel. Furthermore, once the economy begins to recover, I see oil going to a fundamentally sound $70/barrel over the next 2-3 years. All this results in pump prices for people to average a little less than $3/gallon for the long term.
Disagree with me? Don't keep it to yourself. Let’s start a dialogue.
Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!
The Standard Disclaimer:
The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.
© 2009 Sahil Bhatia
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