Oil’s Well that Ends Well

03/19/2012 8:00 am EST

Focus: COMMODITIES

Peter Way

Founder and CIO, Peter Way Associates

Looking at what traders are doing, as opposed to what talking heads are saying, gives you a much clearer view of the global energy markets and what you can expect to pay at the pump…and thus, what you should put in your portfolio, writes Peter Way of Block Traders’ Oil & Gold Monitor.

Iran, the Straits of Hormuz, Israel, US elections. All of these notions, among others, factor into the price of gasoline at the pump, and therefore virtually all energy investments. How will they play out?

More importantly, how will you get your head around it all?

One approach is to try to know as much about each facet as Hillary Clinton, Benjamin Netanyahu, Karl Rove, and the energy bankers at Citi, all in combination.

Another approach, we think a better one, is to set aside the minutiae of all that and go directly to the conclusions that matter most: Just how far may stock and ETF prices run, how soon, and how likely is it to happen? Conclusions reached by knowledgeable, highly motivated people whose actions can’t lie about what they really think.

Regular readers know that for a long time we have been providing those odds and potential payoffs (good and bad) as they evolve. And evolve they will.

Stock prices are the product of human perceptions and anticipations, subject to inputs from a worldwide, technologically complex civilization of sentient beings that all have their motivations. We simplify the process by resolving it down to the tradeoff between fear and greed.

That tradeoff is clearest among the volume market makers aiding big investment organizations to make changes in their portfolios, and the proprietary trading desks that sell them the price-insurance protections needed to bring the transaction liquidity of market-maker capital into the process.

Both buyers and sellers of the protection find common ground that most satisfies their desires. From their willingness to act, and the prices paid and received, we determine the extents of the protections involved—a price range believed possible to be encountered within the life and scope of the protection purchased.

But those forecasts need to be tested to see how likely they may play out. From our decade-long daily histories, we have a pretty good idea of how close to the mark may be each stock’s current tradeoff of upside price change potential against its possible downside exposure. Actual experience tells the odds of how likely the forecasts may come to pass.

It’s not a perfect process, but we don’t have ready access to Hillary, Ben, Karl, or God.

When it comes to expected prices of crude oil and precious metals, the same process can be effective. That may make it a bit more comforting to have a sense of the coming environment behind such investments.

In the case of crude, we have enormously liquid (no pun intended), active, worldwide markets in futures prices, which themselves are forecasts. But settlement prices there are like in stocks, single-point, with little common indications of the size or shape of the lurking uncertainty.

So we use their hedging actions to get an additional insight to what may be coming. And the settlements suggest gradually declining crude prices, from the $110 a barrel level down to the upper $90s.

Industry hedgers and financial speculators foresee possible exposures to Crude prices as high as $130 to $140-plus in most months of the next couple of years. But the notion of much decline is not readily accepted. That backdrop suggests a fairly positive environment for energy investments, at least those driven by oil.

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