Don’t Be Surprised If Oil Prices Hit $20

20 Dollar Oil

Is $20 oil Possible? This question has been asked, and answered, in previous Oilpro posts. Yes, $20 oil is possible. Will it happen? I don’t know. But it is worthwhile to understand why a $20 price is not out of reason. Further, it might be instructive to understand why recent oil price commentators are suggesting a low-thirties number.

A year ago it was almost impossible to get an article published that talked about $60 oil. That price was believed to be completely unreasonable. Now we are flooded with commentaries speculating on “How low will it go?”, with $30-40 numbers quite common. It now takes $10 or $20 to reach the “sensational” threshold. But is the $20 number of today the same as the $60 number a year ago? Is it just a matter of time? To answer that question we need to remind ourselves of the way prices happen.

Forget everything that you have been told or that you think you understand about the way oil price happens. Here is the real story in today’s world.

We will use the price of gasoline as our example. Other oil products follow a similar pattern. We begin at the end — pumping gasoline into the tank of our automobile. What price do we pay at that point? The price posted on the pump, of course. Do we negotiate the price with the fueling station before we pump? Of course not. If we tried, the service station owner would roll his eyes and turn to a sane customer. Thus the ultimate sale price of oil sold as gasoline is determined by the service station owner.

Where does the service station owner get his price? On the invoice that comes along with the tank truck delivery by the wholesaler. He tacks on his margin of a few cents and posts the resulting number on the pump. Where does the wholesaler get the price he puts on the invoice? From the refiner/supplier. He will add a few cents margin to the wholesale price and that is the number that appears on the invoice to the service station owner.

Where does the refiner get the price that he puts on the invoice to the wholesaler? Here the details of the story get somewhat cloudy, but the result is clear. The number that appears on the invoice that the refiner presents to the wholesaler is the price set by someone in the marketing department. You might say that Rex Tillerson provides that number for Exxonmobil, and he does bear the ultimate responsibility for that number, but he delegates the actual number-crunching to his underlings. Where then does the underling get the actual number that he instructs be applied to the wholesaler’s invoice? This answer is the key to our understanding, so I will elaborate.

If one listens to distinguished professors, elite analysts from financial institutions or industry associations, or television talking heads, we might be advised that this price is determined by 1) the price of crude, 2) the cost of the highest cost production, 3) the average cost of production, 4) the cost of a competing fuel, 5) OPEC’s production level, 6) world spare capacity, 7) OPEC’s quota, 8) OPEC cheating or a myriad of other reasons. All are wrong. The number cruncher in the refining company gets his number directly from the published prices on the oil futures exchange. His price, therefore the refining company’s price, therefore my price is directly created and supplied by the CME Group, the company that operates the oil futures exchanges.

We then are left with the question “How are futures prices determined?” Do the futures traders analyze world supply and demand on an instantaneous basis, factor in the cost or production from a million wells, assess and quantify the transportation element in each oil movement worldwide and then apply that complicated assessment in his price outcry? Of course not! He knows nothing and cares less about all those factors. He is merely guessing whether the price he is bidding or taking will be better, in his direction, in a few seconds, minutes or hours. It has nothing to do with oil, other than the name on the contract. When one realizes this fact it is appalling that this activity determines the price of oil. It is even more appalling that people who advise us and should know better suggest that the “market” is wise and, in fact, knows all.

Now that we have established that the actual price determination is whatever price results from transactions between futures traders, we should be in a position to gauge the price range that can occur under these circumstances. The answer to that question is “Anything”. There are no limits to the numbers that futures traders are willing to consider since the absolute number has no meaning. The only guess is whether it will be higher or lower on the next trade. By recognizing this fact we can appreciate why the duration of a trend is the only important element in judging how high, or low, the price can go.

Are we then left to conclude that the price can be as low as zero and as high as infinity? Theoretically, yes. Practically speaking, zero is not really a lower limit for short periods. And the upper limit is probably restricted to the availability of margin money. But unreasonable prices in either direction are possible.

But, you protest, we have been taught that there is a relationship, in fact an equilibrium, between price and supply as well as price and demand. So wild movements in either direction cannot occur! Your protest is denied. Time is of the essence. Futures price movements occur in microseconds. Establishing an approach to equilibrium between price and demand is on the order of a year or two. The equilibrium time for supply approaching a price-determined level is probably decades. Microseconds beats out years or decades every time. So the futures-created price can be unreasonable for a long time. As a futures trader once commented, “I can keep prices at an unreasonable level longer than you can supply margin money”.

Now that we understand the reality of pricing, let us return to the initial question. Can the price of oil go as low as $20? Of course it can. Can it go as low as $10? Of course it can. Will it? Who knows! But for guidance we might take note of the mechanism that is widely used by the trading community for “guessing” price moves.

Historical charts are prepared for hourly, daily, weekly and monthly price history. There are peaks and valleys. A previous valley is a “resistance” point, as is a previous peak. These are also “target” points due to “stops”. The current valley is about $44. It is likely that that valley will be reached soon. The next valley is about $35. Already John Kilduff is pointing to that level. More trading-oriented commentators will jump on that bandwagon, and their concerted thinking will be self-fulfilling. So $35 in the next few months is quite likely. Since highly-leveraged speculation always overshoots, a panic move in the $35 level can easily see a spike into the twenties. So be prepared.



Aurthor: William Edwards