Oil Price: More Than Just Another Number

Quick, what is the price of oil? For a number that is so frequently quoted by market analysts and casual observers alike, the market price for a barrel of petroleum is actually rather confusing. Not only is this value constantly changing, but the question is woefully unspecified. The price is highly dependent on the type of oil, as determined by its specific gravity, sulfur content, and location. As a result, the price of Saudi light sweet crude (which requires less refining) is higher than Venezuela's heavy sour quality.

To complicate matters, most oil is not traded on exchanges, but through over-the-counter contracts in which two parties settle on a price for future oil delivery. In general, however, the oil price references one of the major benchmarks like WTI Light Crude, ICE Brent Crude, or the OPEC basket. For the most part, these benchmarks trade within a close range of one another allowing industry analysts to create a composite "world oil price."

More recently, however, a yawning WTI-Brent spread has begun to alarm traders. Under normal economic circumstances, the higher-grade WTI trades at a premium of $1-$2 per barrel over Brent. But last week, WTI was priced at a record $11.73 discount against the North Sea-based Brent benchmark. According to financial reporters, this price reversal is a logistical artifact, and does not reflect true market realities.

The problem can be traced to Oklahoma of all places. West Texas Intermediate (WTI) is shipped to Cushing, OK where US suppliers store the oil until the delivery contracts are settled. JBC Energy reported that inventory stocks in land-locked Cushing were at 27 million barrels, almost triple their number back in November. Two forces are causing inventories to rise. First, demand is slumping and thus suppliers are drawing less oil from the Cushing facility. Second, there is currently a "super cantango" in the WTI oil market. This phenomenon results when the spot contract (immediate delivery) is much cheaper than the future contract. Oil traders are hereby encouraged to buy discounted WTI, store it in Cushing, and then take the profits on a futures contract.

The Financial Times is reporting that the current WTI-Brent price dislocation could spell trouble for one of the world's most popular benchmarks. If WTI is dominated by technical variables like inventory stock, its ability to reflect broader market conditions is diluted. By definition, this distortion threatens the viability of WTI as an indicator of oil fundamentals.

While there is considerable difficulty in finding suitable benchmarks for the oil price, there is a growing consensus around the cause of its rise and fall: hedge funds. In early 2008, sensing an economic slowdown, hedge funds moved trillions of dollars out of equities and stashed their money in energy Exchange Traded Funds (ETFs). These ETFs are basically tax-efficient, tradeable mutual funds whose profitability was based on hydrocarbons. With global oil demand rising (estimates were based development in China and India), hedge fund managers saw these energy ETFs as a rare safe haven in a bleak trading year.

In just a few months, however, an economic slowdown became a full-blown credit crisis. To cover losses in the stock market, hedge funds were forced to raise cash and begin a painful deleveraging process. As they liquidated their positions in energy ETFs, hedge funds sent the oil price into a fantastic downward spiral. It is important to note that as oil lost three-quarters of its value, demand was trimmed less than 10%. Clearly the petro-bubble was exacerbated by market speculation.

Now, with the oil price lower than the cost of production, there is a dearth of new investment for exploration, extraction, and refining capabilities. Once inventories are sold off, it could be difficult for oil suppliers to meet future demand, even with a global recession. What is more, many analysts suggest that oil is vastly oversold, with Goldman Sachs predicting a rapid price reflation in late 2009.

Just this week, there are reports that several banks have purchased supertankers that will store cheap oil until the price advances again. According to Bloomberg reports, Morgan Stanley is paying $68,000 per day for its tanker. At that rate, you can bet their analysts have thought long and hard about our opening question.