Oil closed on Nov 3 at 59.14 USD per barrel. These days there are some jittery news that could cause the price of oil to increase. Cramer in his 24-10-2006 podcast said that oil futures were driven up by the hedge funds. I agree and said so in July and Fortune said the same in May of this year. History is that, history, and the question is, where is oil headed in the future?

Let’s start with the basics and see where oil futures are trading. At the NYMEX the oil futures are trading as follows:

  • Dec 2006: 59.15
  • Jan 2007:  60.88
  • Feb 2007: 62.10
  • Mar 2007: 63.08
  • April 2007: 63.87
  • May 2007: 64.51

The various contracts are indicating a higher price as time goes. The increments are moderate, but they exist. I want to focus on the Mar 2007 contracts. Looking at the call options, combing the strike and price of the option the price of oil is hovering for the most part under 70. Looking at the put options they are hovering below 65 for the most part. The traders seem to think that oil will probably trade in the 55 to 75 USD window, with the median probably being around 65.

I think we are headed for very quick knee jerk of increasing oil prices. First it seems hedge funds are slowly moving back into energy. Second, we are headed into the winter season and typically there is more demand for oil and more volatility. Third, Iran is making subtle hints sanctions might hurt others as well. Working against increasing oil prices is the prediction of Environment Canada for a warm dry winter. If sanctions are weak, and the winter is warm it means lower oil prices.

I think there is going to be a quick oil price run-up because of a conversation I had at doggy school. My wife and I regularly attend doggy school with our two English Bulldogs. At the school Louys our male Bulldog has a friend call Xena a Doberman mixture. The owner of Xena is a farmer and we were talking about the weather. I explicitly asked her about the winter. Her reply was, “Yeah it seems like a warm winter, but oddly our horses have an extremely thick fur indicating a cold winter.” We live in Switzerland and her comment was that we would have a cold winter in Switzerland.

In the referenced Environment Canada article prediction wise they are saying warm, but the farmers alamanc is saying cold. What do you believe? I am tempted to think that the farmers might have a nugget of truth that will be exaggerated by the market due to other “factors” such as Iran, Iraq, you name it. So if you have some money to burn on a risk that could pay off, again this is REALLY risky money, buy a March call option at 64.50 for 2.75 or 65.00 for 2.55. If a knee jerk reaction happens I am tempted to believe oil will go over 70, maybe 80 for a short period of time before falling again.

For the near to medium term the trading range of oil should be 55 to 65. My earlier prediction that oil will touch 45 I am stepping back from

Doesn’t it seem strange that futures prices are higher than current prices? What products sell this way? Think about it, if you were going to buy something, like a computer or a TV, would you be willing to pay MORE for delivery in six months than to take delivery today? Of course not. You would just by the TV or computer today and be able to enjoy it today while saving money.

The oil futures markets are exhibiting a very unusual price structure, usually you receive a discount for waiting for delivery.

The futures markets have a name for the unusual situation when future prices are higher than current prices, it’s called contango (anyone know why, i don’t). What it usually indicates, however is an excess of inventory. The only reason you would pay more for the TV in six months (and not instead take delivery today) is if you had no where to put it, or were concerned that you would have to pay for retransport (moving). So you might be willing to pay a bit more, because it would save you the money for storing it for the six months to the time when you really think you want it. This is exaclty what is happening in the oil markets. There is now so much inventory that the cost of storing the oil has skyrocketed. So, rather than manage storage, people are willing to pay a premium to take delivery in six months, when they assume that they will be able to sell it at even higher prices.

This is important – most of these purchases are speculative. As inventories continue to rise, however, prices should fall, since, at some point, it will simply be more profitable (or less costly) to unload the oil rather than to hold it, particularly as cost of holding inventory rises. This is why we are seeing large drops in oil prices – the hurricane season turned out to be mild. Those speculators who were hoping to hoard oil and sell in a squeezed market realized that there was not to be a squeeze, and needed to get out of positions before the carrying costs ate them alive.

I know this may seem surprising, but I believe the price of oil is headed down, not up. Prices have been held above “market clearing” price as everyone has raced to build inventory. The end of inventory building would unleash more than half a million barrels of supply for consumption overnight. And as inventory builders realized that they might have to take big write-downs on the value of that inventory (as prices fall), they will be encouraged to become sellers as well, further increasing supplies. This of course, is short-lived, as there is only so much inventory).

My biggest concern is that neophyte commodities investors are making bets on the oil markets that say oil prices should rise in summer because gas prices rise in summer. In the US at least, this is true, but the primary reason for the increase is not changes in the price of oil, it is the cost of the additional fuel additives required by various US states and municipalities.

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[…] A reader of my previous energy update said what I was thinking: Doesn’t it seem strange that futures prices are higher than current prices? What products sell this way? Think about it, if you were going to buy something, like a computer or a TV, would you be willing to pay MORE for delivery in six months than to take delivery today? Of course not. You would just by the TV or computer today and be able to enjoy it today while saving money. […]

[…] A reader of my previous energy update said what I was thinking: Doesn’t it seem strange that futures prices are higher than current prices? What products sell this way? Think about it, if you were going to buy something, like a computer or a TV, would you be willing to pay MORE for delivery in six months than to take delivery today? Of course not. You would just by the TV or computer today and be able to enjoy it today while saving money. […]