It seems to me that commentary on oil prices has reached epic meme proportions, so it tickles my sense of cynical irony to put finger to keyboard with a post on oil prices.

My primary motivation, apart from simple glee at joining the lemming herd decrying the collapse of oil prices, is to add a financial planner slant to interpretations of oil price moves as well as market movements and media commentary that flows from such moves. I know – it’s quite a big brief – but I do type relatively quickly, and we’re not aiming at a Pulitzer here – just the sharing of some thoughts and musings.

The title is based on an interesting article that talks of an oil company actually paying someone to buy their oil.

Executive Summary

The price of oil is globally important, and as a primary input cost it has potential to alter pricing fundamentals across a range of seemingly unrelated areas. While price movements are inherently volatile, investors should be wary of allowing individual sector movements of any kind to influence their longer term plans or strategies. However, no investor lives in a vacuum, and today’s 24 hour news cycle can amplify the apparent impact of short term price or market movements, causing investors to act in a hasty or imprudent way. None of us really want to be accused of doing this but resisting the pressure of news cycles and social moods can be horribly difficult. This article seeks to use the oil price “collapse” and reactions to it as a proxy for investor sentiment generally in the face of seemingly dramatic investment conditions.

Surprise! Markets are volatile

The standard imagery presented for markets (and it doesn’t matter which – share markets, property markets, bond markets, iron ore/coal or oil markets) is one of lemming-like behaviour, where a horde of investors rush to overtake each other in a stampede in one direction or another. Up, down or off a cliff – it doesn’t really matter. This is how investment is often viewed. And much like the lemming myth itself, this is mostly illusory as the reality is something quite different.

What impacts on oil prices?

The price of oil is dependent on a range of factors, each of which may act independently or in direct relation to any of the factors. So it’s a web of possibilities.

[Image courtesy of num_skyman at FreeDigitalPhotos.net]

Each of these factors will cause or trigger a change in expectations and a need to react through buying or selling more or less oil. You can most likely bring them to mind as easily as I can:

• Oil usage. Itself dependent upon a host of inputs such as weather (which most noticeably impacts the USA’s “driving season”); economic activity (planes, trains and automobiles, ships and electricity generation); technological change (improved fuel economy, changing fuel preferences); alternative energy competition (such as biofuels, solar, wind, hydroelectric, nuclear and whatever else). Environmental awareness can bring consumers to seek more ways of reducing oil and energy usage.
• Oil transport costs. The largest producers are not necessarily close to the largest consumers, so oil has to traverse the globe in order to reach the end consumer. This involves costs for freight, insurance, storage, and stevedoring.
• Oil storage. Now that’s a strange one, isn’t it but it does have at least some impact. It isn’t really a “usage” as such but When oil prices are low and traders think they will rise in the near future, floating tankers and onshore storage facilities are leased and filled with cheap oil in the hope of selling it for a profit when prices rise. In addition, nations will seek to retain a “strategic supply” of oil to buffer in case oil supplies are temporarily suspended or reduced. The US version sees around 695 million barrels of oil stored in mountains and facilities around the country. China is gradually increasing its supply to reach its preferred minimum reserve level. These can be marginal but material impacts on price.
• Oil supply. OPEC is the oil cartel in charge of a big chunk of global oil supply. Agreements or disagreements between members can alter the global shortfall/surplus which in turn can dramatically impact marginal pricing. Fracking, shale and emerging technologies can alter the underlying “model” of oil supply, with smaller capital requirements, shorter lead times, quicker payoff periods and faster depletion bringing about market disruption to traditional models of decade long development and production cycles. Alternative oil production sources again feed into the marginal but potentially material impacts on price. Iraq or Iran adding to or subtracting supply can have material impacts.
• Futures and Derivatives – otherwise known as ‘pretendy oil’ (OK – I made that one up). Whether hedging against price rises/falls or operating expectations or speculating on price movements, the promise to deliver or buy oil at a future date will feed into price expectations and inputs today.
• Political imperatives. Venezuela may need to pump more oil to keep social unrest under control, and to meet promises made to the populace. Russia may wish to use its petroleum resources to increase its political “soft power” in regions peripheral to its borders.
• Unofficial oil. Iran under sanctions, Libya’s factions seeking to gain money and influence, ISIS aiming at extorting profits from captured facilities and Kurds seeking funding when central government isn’t able to provide it. There are many reasons why oil may reach markets through “unofficial” channels. In a “normal” market, these may be incidental but when a market is pricing at more extreme discounts or premiums then these marginal inputs gain greater impact and can become material at some level.

So any, some or all of these inputs could and would impact on price at any given point in time. And it’s not just the inputs that change.

There is also the simple basics of which oil price you are measuring..

Because there isn’t just one type of oil. There is low-sulfur sweet crude, sour crude and most likely a host of other crudes as well as the not-so-crudes, including distillates, byproducts and subproducts (again, I made that one up but other than my dodgy naming convention, the usage holds true). This diversity is clear when looking at pricing conventions – Brent Crude, West Texas and a raft of others.

There are also processing and secondary costs that come into play, in a reverse impact on oil prices. For example, if processing and distribution costs amplify the price at the consumer level then this can dampen demand which in turn feeds back to the marginal price on offer for a given unit of supply.

How low can oil prices fall?

This is where the various inputs into oil prices are thrown into a formula of one kind or another, and the answer is adjusted by whatever future variables the analyst / commentator / adviser may think are most likely.

And this is where any such predictions must be treated very carefully. The key point is to remember that they remain PREDICTIONS – and are therefore subject to the same errors, irregularities, imperfections, misinterpretations, bias and probability errors as any other market prediction.

Most predictions will fall within a relatively small range, usually based on taking whatever is the case today and adding or subtracting a bit. There are various reasons for this but the key point is that a hint of cynicism can be a good moderating tool when looking at market price projections – as even a firmly held consensus among those considered authoritative and capable, can be found to be completely wrong when events subsequently play out.

Of course, the further prices move from consensus or expectations then the more radical become the interpretations – such as these from the Independent website, which compare the price of oil to a barrel of water or a pair of pants!

Oil prices have moved by very large amounts in the past, and will most likely do so again the future. Anyone remember the calls by some analysts for a $200 target oil price – the price actually hit a peak of $145 according to Wikipedia here. There are now calls that oil could hit $18 or even lower. Always remember that these are predictions, and no more than that. Keep an eye out, there is bound to be someone, somewhere who will call a price of $10 a barrel. Again, it’s just a prediction and the wilder the predication the greater the kudos in the unlikely event it turns out to be a correct call – so there’s quite a bit of potential for fame by making an out-of-consensus prediction. And that just highlights the need to be wary of giving too much credence to predictions in a volatile market of any kind.

Boring old Diversification

And this is where a financial planner will generally step back and nod sagely, while being thankful that they aren’t in the business of trying to trade goods or commodities! Nor is a planner generally going to recommend an overly large exposure to any one specific area, as the range of probabilities become too large which in turn reduces the likelihood of a financial plan coming to fruition.

In the case of oil, we can look at diversification in a reverse sense.. Moving along the lines of risk and reward for various forms of exposure to that gooey black stuff.

• An Exchange Traded Fund (“ETF”) that mirrors the price of a specific oil price index – such as Brent Crude
• A derivative contract with exposure to the oil price
• A fixed income investment based on an oil company
• Shares in an oil company
• Shares in a range of oil companies
• A portfolio of oil sector credit or income notes
• Shares in a company associated with the oil industry
• Exposure to the broader energy sector
• Exposure to Resources and Commodities
• Exposure to broad market indices
• Exposure to global market indices

In each case there will be an exposure to the impacts of oil prices but the impact of a given movement in the price of oil will have a greater or lesser impact on your investment depending on how you have chosen to gain your exposure.

This may seem self-evident but it is my experience that it can often help to refamiliarise yourself with the obvious and self-evident. Doing so can help reduce the influence of other people’s opinions or expectations, which in the field of money can be a very helpful exercise.

The Great Disclaimer

Please always remember the Great Disclaimer. Nothing in this post is to be taken to be personal financial advice. It is general advice only, and if you’ve taken the time to read this particular post then you’ll see that it is even suggesting that “general advice” can be a dangerous thing. So, you should not take any action in regards to your own position, strategy or finances based on this post. Really, that would be a crazy thing to do.

If in doubt, always seek an appropriately qualified person who can look at your own situation and interpret whether this or that point is relevant to you and could impact on your plans.

For those who like their disclaimers served up in buckets, you are welcome to visit my blog www.michaelsmusings.com.au and see the “Warnings and Disclaimers” page for lots and lots of important notes on things to be careful of when looking at ANY information on the internet.