The Fundamentals Behind Crude Oil Price Movement

03/29/2010 11:15 am EST

Focus: COMMODITIES

It would seem that the normal laws of supply and demand would be the foundation for establishing the current market price for commodities like crude, and to some extent, this is the case. However, when speculative interests are taken into account, the picture becomes fuzzy. While millions of barrels of crude oil are bought and sold each day, consumers and producers look to hedge the risk of a change in price for the raw material before they make the purchase. This is where the futures market comes into play, and subsequently, where trading conditions become distorted. How does the market come to its fair value price of crude? What is the most influential driver for this specific commodity? What factors are best to watch to determine the direction and intensity of a crude oil trend? Let’s take a look.

Risk Appetite Invites an Unpredictable Element to Price Action

As is the case for most growth-sensitive assets, crude oil’s general pace is the product of two distinct drivers: Market-wide risk appetite and the prevailing balance of supply and demand. Investor sentiment is an exogenous catalyst that falls outside of the normal scope of the energy market. The flow of capital is a market-wide concern; and its motivations are unpredictable. A particularly influential and accessible economic release or general shift in the crowd’s mood can be equally influential for price action. It simply depends on the predisposition of the market at the time. But, why does something as subjective as risk appetite have such a prominent effect on price action?

Through futures markets, the normal function of hedging unfavorable price fluctuations by commercial users is exacerbated by purely speculative motives. The inclusion of a speculative element in the market increases liquidity and price discovery, but it also exposes the commodity to a segment of the market that has no interest in dealing in the physical. What’s more, the rise of commodity-backed exchange traded funds (ETFs) has further drawn in investor interest. Regardless of what particular reasoning for risk appetite to influence the asset, the impact of speculation can be seen through notable correlations. Below is a graph of the active crude futures contract (the grey line) and the Dow Jones Industrial Average (the orange line). Since the reversal from record highs for the latter, the relationship between the two has been distinct. However, the day-to-day volatility and swings between the two holds going much further back.

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Despite its being a prominent driver, investor sentiment’s influence over oil can wax and wane depending on broader market conditions and the quality of risk trends themselves. If, for example, sentiment has leveled off or is progressing at a slow pace, it will invite a greater reaction to more tangible drivers (like supply and demand). On the other hand, this asset class is highly sensitive to a change in optimism. Therefore, an otherwise lax correlation can suddenly return for a short period and disrupt a trend or spark a meaningful technical development.

Back to the Basics

Though risk appetite can often commandeer crude oil price action, the underlying trend is almost always influenced by the natural level of demand among commercial interests. The influence that such a driver has on price action is textbook economics. Consistent demand met with a reduction in supply makes the available oil more valuable.

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Alternatively, a constant level of supply that meets a sudden rise in demand will also increase the value of the existing inventory. However, while the theoretical balance is easy to identify, the influence behind equilibrium is oftentimes not so clear. For example, in the lead up to the record-breaking run in crude prices towards $150 per barrel in the summer of 2008, there was a notable drawdown on inventories in the US (the largest consumer of fuel in the world); but the decline was not unprecedented. More than likely, the advance was the combination of a strong global economy and an abundance of credit and investment capital. In the subsequent plunge that pulled the market down nearly 75% from its highs, the global economy fell into a recession (demand dried up) while supply held relatively constant. During these two periods, tolerance for risk and demand for energy would come hand in hand. This is often the case when it comes to the larger trends in the commodity market.

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However, it is not always easy to gauge the longer bearings on demand or its influence on the market. On the other hand, regular reports on inventory change, demand forecasts, and production figures from different regions of the world offer a very accessible driver to an otherwise vague concept. While there are different regional readings for this data, the most influential data comes from the largest producers and consumers (especially the United States and China for consumers and OPEC producers). For accessibility, there is no other reading that is as accurate or timely as the Department of Energy (DoE) inventory figures for the US.

This week-to-week reading of stockpiles for the world’s largest economy is frequently the impetus for substantial volatility, but not always. Depending on the market’s preexisting level of volatility and the interest in risk appetite trends, significant changes in inventory figures can lead to significant moves in the commodity itself. Below is a chart of the DoE’s crude oil inventory report (in grey) and the industry-based American Petroleum Institute’s (API) reading of the same thing.

Over time, these two measures move in the same direction much of the time, but the weekly changes can differ substantially. Yet, there is very often little response to the API figures, while the DoE numbers receive far greater attention. Given the considerable correlation over time, the difference in market response to the readings is somewhat surprising and a source of potential exploitation.

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Further keeping with the supply and demand picture, demand for crude does not typically come from the consumer. Oil is a raw material that is further refined into gasoline and heating oil, which themselves are heavily used by consumers and businesses. Therefore, the consumption of crude is heavily influenced by the changes in demand for the processed energy products. To illustrate this relationship, we can highlight the seasonality effect of the driving season in the United States.

During the warmer months of the year and coinciding with a number of holidays, Americans generally travel more, and in turn, reduce the stocks of available gas reserves. To replenish the supplies, refiners require more crude to process. So, while gasoline inventories are not historically market moving on their own, they play a role in defining “pull-through” demand for crude. In the chart below, we see the DoE’s gasoline stockpile change (grey line) and API’s own reading of the same thing (orange line).

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Altogether, trading oil from a fundamental approach is not as simple as economic theory would imply. However, being able to recognize the primary drivers for price action (sentiment trends and the true supply and demand balance) and gauging which is the dominant catalyst for the market at any given time can significantly clear the picture for a trader and put them back in tune with the market.

By John Kicklighter, strategist, DailyFX.com

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