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Given the importance of this "black gold" to our economic future, it might be a good idea for investors to try to make sense of the market, and to be prepared for various contingencies by putting market trends to work for them and hedging against the possibility of oil shocks. This article, through cold data, provides a survey to help you navigate the slippery terrain that is the global market for crude oil. We will discuss crude's impact on market indexes, and how index products can be employed to play or hedge crude oil exposure. The Age Of Cheap Energy Is OverLast year, nearly everyone called $40 oil a bubble. A seasoned investor knows that simply because an asset's price goes up a lot in a short time (even more than 100 percent), it does not necessarily qualify as a bubble. What distinguishes a bubble asset is that its price is divorced from economic fundamentals and long-term relative price history. With hindsight, it is fair to say that $40 oil was not a bubble. But for some, it is much harder to understand why we recently experienced $70 oil. But crude's recent $70 price is not an anomaly; economic fundamentals support crude oil's price. Commodity index price trends also confirm the view that energy assets are neither near the beginning nor near the end of their bull markets; however, the "easy long-only money" has likely been made. Since September 2003, I have been pounding the table while recommending an overweighted exposure to the energy sector. I have favored energy stocks and funds, primarily the Energy Select Sector SPDRs (XLE) exchange-traded fund (ETF) and the Merrill Lynch Oil Services HOLDRS Trust (OIH). I also have supported complimenting equities with New York Mercantile Exchange (NYMEX) energy futures, including crude oil (CL), heating oil (HO2), unleaded gas (HU) and natural gas (NG). I have more company now than last year. More traders/investors are joining the pursuit for higher returns through energy assets. Some are recognizing that the Age of Cheap Energy is over. Phil Flynn, vice president of energy and general market analyst with Alaron Futures and Options, said: Most people overlooked oil and completely took it for granted. And when people are looking away, that's when the most historic markets are born. This was the sewing of the seeds of the most explosive and sustained bull commodities markets of this generation! History was being made and we were a witness to its birth. And as the entire world looked the other way, the world oil market began to change. And change in dramatic ways. Investors are not alone to question a 66 percent rise over last year's oil price. Consumers conjure up a myriad of reasons for high energy costs. I am concerned that they will form unreasonable conclusions such as there being a conspiracy formed by energy moguls and the Bush Administration to manipulate prices. Conspiracy theorists promote irrational responses and keep us from managing our lives and assets properly. This report focuses on accepting a New Energy Era - a time when fossil fuel prices are and remain dear. By a three-to-one margin, Americans hold the Organization of the Petroleum Exporting Countries (OPEC), oil companies and the government responsible for higher energy prices. The public believes that we are swimming in oil. They blame high energy prices on manipulation and temporary supply shortages.[1] This report refutes that thinking. Mr. Flynn can not fathom why investors have not recognized that the oil market has permanently changed. Throughout the 20th century, peak oil prices were caused by supply shocks. Some economists have already begun to talk about Hurricane Katrina as the "third supply shock," the successor to the 1973 shock caused by Saudi Arabia's response to the Yom Kippur War and the 1979-1981 shock triggered by the Islamic revolution in Iran. Katrina is a shock, but unlike past shocks, it exasperated an already-delicate supply/demand balance. Simple Supply And Demand The initial rise in oil prices from 1998 through August 26, 2005, was not triggered by a supply shock. It resulted from both demand pressure and supply scarcity (the inability of new supply to overwhelm demand). In other words, a perfect storm has been brewing since the late-1990s energy depression. Katrina ripped the roof off of energy prices, but as Figure 1 shows, that roof was already in bad disrepair. At the time, world demand already exceeded supply. The roof would have eventually been pried off by gentler winds or another storm.[2]
Katrina was a wake-up call that may foreshadow future energy crises and supply shocks. Crisis presents us with opportunity if it enables us to see things as they are rather than as we wish them to be. Unlike the 1979-1981 surge in crude prices, surges like the current one will not vanish for twenty-four years, because the inherent supply/demand balance is out of whack. Those who accept this premise will manage risks better as they venture through the capital markets; investors who deny this reality will suffer opportunity cost. |
Perhaps no single factor will more strongly affect the economy and global markets than the supply and demand of crude oil. The battle lines are already being drawn, as the recent price shocks and political instability related to crude oil production underscore. In August 2004, crude oil closed at $42.12 per barrel. Near the end of August 2005, spot crude was near $70. It has since fallen into the upper $50 range, which is some relief. But as recently as late-1998, the price of crude oil dipped to around $10 per barrel, with many market analysts saying there was nothing preventing us from seeing $5 or even less.
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