What’s Really Driving The Price Of Oil?

The Internet tends to be a Wild West of opinions on investing, but I think some of the best work actually documenting and comparing the various sources of information on energy and petroleum is over at The Oil Drum. Now, to be clear, they don’t claim to be an unbiased news source; their bent is pretty firmly in the peak oil camp. But they regularly feature dissenting voices and academic debate, and consolidate raw data, regardless of whose point it makes.

One of the site’s best regular features is the Oilwatch, a monthly consolidation of new oil statistics. Cruising through last week’s issue, I was struck by this chart:

I had a hard time marrying that chart against the short-term news reported by Brad Zigler last week. In his piece on oil stock drawdowns, he correctly points out:

If you’re long oil, it’s easy to see numbers like that and get excited. Usually, however, big drawdowns mean supply-demand imbalances, right? But unfortunately, energy markets are rarely that fickle, or that predictable.

The challenge is figuring out which of today’s numbers matter for both the short and the long term. Personally, I think the long-term trends are more important, as I’m more of a long-term investor. The OECD demand chart tells me a story of a recovery barely getting by, and certainly in no danger of springing into action with millions of barrels of unexpected demand per day.

And consider this chart of the inventories at Cushing, Okla.:

Current inventories have not quite exceeded the May peak, but let’s face it: They’re still at ludicrously high levels. Ultimately I believe that the longer-term returns—returns seen over a period of weeks, not days—are more correlated to how much oil is overflowing the Cushing tanks, rather than daily updates in supply and demand.

By no means is it a perfect negative correlation—after all, there are many, many factors that push on the price of oil—but over the last 10 years, the correlation of inventories and prices on a monthly basis is -0.14, an entirely logical occurrence.

So while the moment-to-moment data on crude inventories might have been temporarily tight, I’m forced to look at these long-term trends and determine that we may be in more of a glut than a drought. And frankly, I think the futures markets agree with me. Consider the contango curve on WTI crude now versus a year ago:

Brad pointed out correctly that the black line here, which is the current state of contango, has steepened just a bit recently, but it’s nothing like the crushing contango the market had at this point last year. For those of you more inclined toward actual numbers, here’s the monthly roll yield cost as of Friday, and a year ago:

Crude Oil, WTI (NYM)
8/6/2010			8/7/2009
Period	Price		Price
1M	$ 80.70		$ 70.93
2M	$ 81.18	0.59%	$ 72.78	2.61%
3M	$ 81.77	0.73%	$ 74.08	1.79%
4M	$ 82.35	0.71%	$ 74.91	1.12%
5M	$ 82.90	0.67%	$ 75.71	1.07%
6M	$ 83.40	0.60%	$ 76.44	0.96%
7M	$ 83.83	0.52%	$ 77.06	0.81%
8M	$ 84.22	0.47%	$ 77.60	0.70%
9M	$ 84.59	0.44%	$ 78.10	0.64%
10M	$ 84.94	0.41%	$ 78.58	0.61%
11M	$ 85.27	0.39%	$ 78.96	0.48%
1Y	$ 85.49	0.26%	$ 79.23	0.34%

That front-month roll, which an ETF like the US Oil Fund (NYSE:USO) must do, only costs 59 basis points right now. That’s much better than the 2.61 percent instant loss investors ate a year ago.

Alas, this collapse in contango hasn’t really been enough to make the simple futures strategy worthwhile, as a simple look at (NYSE:USO) returns over the last year will show:

Since last July, a hypothetical spot crude holder has just about managed to hang on to their money. Front-month futures investors, however, have paid a 5.6 percent contango tax, making the bet on rising crude prices not just wrong, but actually costly.

Where does this leave us? Range-bound on oil, is my take. With oil ping-ponging between $70 and $90, consistently unpredictable month-to-month numbers on supply and demand, and no meaningful global impact from the Gulf oil spill, it’s difficult to make a case that there’s anything but status quo in oil’s near-term future. And that status quo contains only one real certainty: the persistence of contango.

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