The Oil Drum

72 comments on A Closer Look at Oil Futures

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jkissing on September 4, 2006 - 6:05pm

It is often said that high prices will cause recession(s) which, in turn, will cause oil to drop in price. In the seventies there were three recessions; the avg oil price, while volatile, never declined yoy. So, my guess is that once supplies begin to decline we will have permanently increasing prices, regardless of economic output. However, I agree there are some events that would cause price and consumption to decline sharply, and certainly bird flue is one of these.

It is clear that oil futures markets do not see real shortages post 2010. Hedge funds don't make long term assumptions, they mostly look for and ride trends. However, many investors in US E&P's are quite aware of po theory, and many of these, including myself, are investing on this basis. THe problem with futures is you can be right in the long term and get crushed short term.

My own preference, shared by many, is to invest in small US E&P's with low cost, growing reserves and earnings. These are companies that, by my definition (which counts reserves equally with earnings), are not yet fully valued in the marketplace. As such, they are usually bought at some point by larger companies having difficulty increasing their reserves; four of my former picks were bought last year. My current favorites are ard and gpor because, in addition to having the highest rating based on my own formula, analysts are projecting record earnings to continue at least through 07 based on oil prices somewhat lower than today's.

I avoid companies with foreign assets. Revenues are generally stable while price is steady because the host country needs expertise and capital that they don't have. However, when price jumps, the host country thinks foreigners are making too much from the national treasure, and accordingly reneges on the contract, raises taxes (often retroactively), or both. Russia, Venezuela and Bolivia are recent cases in point. So, the investor may (or may not) retain his investment, but does not share in the price increase. And, it is anticipation of price increases that attracts po believers to oil and gas investments in the first place.

Regarding gas, the current NA overhang caused by last year's warm winter has held storage at record levels, and the record looks to continue through the first week of Nov, usually the last week that gas is added, and maybe througout the winter unless significantly colder than usual. As a futures contract moves towards the front, it comes face to face with real supply and demand vis a vis the spot market, at which point it has, for months now, crumbled. Futures players are still thinking that gas and oil are bound by their traditional relationship based on heat value. However, the record storage, combined with the ongoing departure from the US of fertilizer and plastics precursor manufacturers, is causing a rolling crash of gas prices. There may be a crash in NA production in a few years, but profits will be under high stress for several quarters. Meanwhile, long investors in gas futures contracts have been losing money quite steadily since the first of the year, and imo this will continue for some time.

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Nate Hagens on September 4, 2006 - 8:48pm

I agree with you regarding US E&P companies and will write more on that in the future. But what happens if there is a windfall profits tax? Or a market-wide selloff? Do energy companies underperform futures? And regarding US vs foreign reserves - we are scraping the bottom of the barrel so to speak on a net energy standpoint (and a dollar standpoint) on some of our older fields (except for the GOM). The higher EROI (and profit) oil sources are found internationally - so there is a tradeoff there.
Natural gas has plummeted its true, but only the 2006, early 2007 contracts - out to 2012 there has been only a minor selloff. The short term glut vs long term dearth is causing new dynamics in the natural gas futures market (I had a portion of this post on that but couldnt get it formatted correctly). We have enormous volatility in current NG market - 25% in last 10 sessions alone - with hurricanes and cold winter we might have shortages - with no hurricanes and mild winter - we have glut to the point of flaring. How can policymakers plan around that?

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jkissing on September 5, 2006 - 11:04am

There will not be a windfall profits tax while bush is president. After he leaves, there may be a change in taxes, but with US reserves running out, no tax will focus on e&p's looking to develop old fields or find new ones. Of course there will be market wide sell offs - thre have been three since I began investing in e&p's eighteen months ago, the shoulder seasons are dangerous. That is what volatility means - however, as long as the long-term direction of oil prices is up, these companies will continue increasing profits; I simply stay in because timing is too tough. Regarding US vs foreign - the last 1% from the old fields might fetch as much as the first 99%, and represent more profits to boot, which is the main point, and meanwhile there is no risk of nationalization. The majors have no choice - they produce so much that they must replace their older, labor-intensive US fields with foreign ones. However, the majors are not as profitable as the small e&p's (I measure this as net/production), and, equally important, are not growing reserves as are a few small ones.
Policymakers aren't doing much one way or the other anyway, the question is, what are investors, or e&p's for that matter, to do while gas price remains soft? Some investors will move away (like me), some will hold, few new investors will buy into gas right now, so shares will ease back and become a buy at some point in the future as we get closer to where prices reverse to the upside, maybe sharply (my moving away from gas is timing, not my strong point, will see if I get it right this time). E&P's will carry on in a more difficult environment because they have expenses to pay, maybe not contracting for quite so many rigs (85% of us rigs are looking for gas), freeing up some rigs to look for oil.

Hurricanes did not take that much gas off production, we still entered last winter with a very comfortable storage, higher than the five-year avg. THere was never a time when storage justified last winter's record prices... this was a case of market irrationality, maybe hedge funds pushing too hard. There is no chance we will not have a record amount in storage, my guess is we will add at least the avg of the past ten years thru the first week of nov, usually the last week that storage is added, meaning storage will climb from the current 2905 to 3725. I see the front month dropping to around 6/mcf every month through next summer... and, even at these lower prices, fertilizer and plastics precursor manufacturers cannot compete with foreign suppliers closer to cheap cas, not least qatar, so the us is quickly shedding around 20% of gas demand as we move to import more of our energy needs.