Over the holiday weekend, I watched There Will Be Blood, the story of an oilman at the turn of the century. Oil was so plentiful in parts of California during that time that it literally seeped out of the ground. Do you think, Perhaps those days are now behind us?
I also watched a political strategist lambaste the oil companies and the speculators for manipulating oil prices. This guy apparently missed his Economics 101 class. If politicians don’t understand the basics of supply and demand, it’s no wonder there isn’t a viable longer-term energy policy in place in this country.
Were the oil companies and futures traders manipulating prices downward 10 years ago when a barrel of oil was significantly cheaper around $20? The facts are that the major global oil companies combined own less than 6 percent of the global proven underground crude supplies. Most of these supplies are owned by Organization of the Petroleum Exporting Countries (OPEC), such as Venezuela, Saudi Arabia and Iran; non-OPEC producers, such as Russia, Norway and Mexico; and certain importers, such as the US and China.
There’s a lot of oil in the US and China. However, the daily demand exceeds daily production. And there are many other importers, including Japan, that have no supplies at all. Add in that production is declining in Mexico and Russia as demand from emerging economies such as India and China grows by double digits annually. It’s basic supply and demand: Economics 101.
If you didn’t see the T. Boone Pickens interview on CNBC last week, it’s worth watching.
What were Pickens’ main points? The world can now produce 85 million barrels a day, and that’s it. Global demand is 87 million barrels a day and growing. It’s not the evil oil companies or the futures market speculators that have pushed gasoline to $4 a gallon in the US. It’s basic supply and demand.
The peak oil theory is proving true. This is the idea that production in the world has peaked and will drop off. Since 2004, it has plateaued. However, demand is increasing as supplies in the US, Russia, the UK, and Mexico decline; it’s a canary in the global energy coal mine.
In the US, we’re paying out $600 billion a year to import oil. This is an unprecedented drain on American wealth, and much of this money goes to people who aren’t particularly interested in our national security. Therefore, this is a security issue as well as an economic issue.
Where's our national energy policy? Little was done in the last eight years. But, then again, little was done to wean America off of the oil addiction over the last 30 years.
Why can’t one of the presidential candidates offer a vision for energy independence similar to the vision John F. Kennedy presented to put US astronauts on the moon by the end of the 1960s? There are many ways to attack this problem. It would help if politicians allowed the oil companies to drill more in Anwar and offshore, but this isn’t likely to happen. And although it might make a dent, it wouldn’t solve the problem.
I found nothing fundamentally wrong with Pickens’ plan. We have two abundant fuels in this country, and natural gas is clean. Pickens also suggested we use wind energy to produce up to 20 percent of the country’s power generation. This would kick out the amount of natural gas Americans use for transportation. The problem could ultimately be solved with the additional use of solar energy; biofuels such as ethanol, which can supplant 5 percent of fossil fuels for gasoline; electric cars and clean coal. But a persuasive leader needs to present that vision.
That brings us to the next question: Where's the price of oil going right now, and how should a futures trader play it?
Oil prices have become extremely volatile. Take a look at the daily chart below.
July Oil Futures: March 2008 to Present
This chart shows the daily price of July oil over the past few months. In early March, July futures traded below $100 a barrel. May 21 oil reached an all-time high price at $135 a barrel. That’s a 35 percent-plus move in just a few months. Because a standard oil contract is for 1,000 barrels, a $1-per-barrel price move represents a gain or loss of $1,000 per contract traded.
Why not just hang on for the ride and reap that $35,000 per contract in just a few months? In the thick of the battle, this isn’t as easy as it appears in hindsight. This is because the daily ranges are now routinely $3 per barrel on a normal day. A decade ago, the price of oil didn’t fluctuate this much in a year.
Lately, there have been many days in which the daily trading range fluctuated $5 per barrel. This is the equivalent of a $3,000 move per contract on a normal day and upward of $5,000 or more on a wide-range session. The late April correction from $118 to $109 per barrel represented a $9,000-per-contract swing in just four days. Could you have comfortably ridden out that one? The trading range fluctuated $6 per barrel May 15.
The longer term is tough, but how hard could it be to simply guess the direction correctly in the short run? This isn’t easy, either. The market doesn’t just move up or down in a straight line. Lately it’s had a tendency to whipsaw nearly every other day.
May 23, for example, July oil futures closed at $132.19, up $1.38 for the day. On that day, I was long at one time, short at one time and out by the end. This wasn’t an easy day on which to trade. What was so difficult?
July Oil One-Day Chart: Friday, May 23
The media will report that oil opened at $130.10, approximately where it closed on Friday. Actually, this price was hit while many of us were still sleeping; by 8 am CST, the market had already crossed above $132 per barrel, on its way to the high price of the day at $133.71 per barrel. The high price was hit before 9 am, when the market proceeded to collapse, at least for a couple hours. Two hours later, oil hit the low price of the day: $130.16 a barrel. That’s more than $3 below the high, equivalent to a $3,550 move per contract.
Even the staunchest bulls would have had trouble sitting through all this volatility. What’s the news? Beats me. I guess those evil futures traders who'd driven the price up to a record high above $135 a barrel earlier that week turned to the good side for a few hours.
However, although it looked as if oil prices were set to close lower for what seemed like a record two days running, oil turned back up to trade above $132 a barrel to close higher on the day. These prices are based off of the active July contract. For the week, oil prices were up $6 per barrel but $3 below the record highs reached midweek.
I don’t know if prices will reach the $150-per-barrel level that T. Boone Pickens projected for this year or if it will fall below $100 per barrel as other analysts predicted. Either way, the market will tell us which way it’s going.
However, I do know two things. First, any upcoming price move won’t be in a straight line. Second, this unprecedented volatility isn’t going away any time soon. Volatility creates opportunity but also magnifies the risks. A risk-adverse investor has no place in the oil futures market these days.
But if you’re willing to assume greater-than-average risk for a greater-than-average return, how do you do it? Is there a disciplined method for capitalizing on this unprecedented volatility without betting the farm?
Here are two rules that I’ve personally adapted for my own trading that may help you cope with this volatility.
First, trade over shorter time frames. I used to trade just once a day, then once an hour. Now, however, I constantly monitor the market while I’m in it. The chart above is a 12-minute chart. In other words, every bar represents 12 minutes of trading. A period this short isn’t unreasonable for a futures trader to confirm or change a decision on an open position.
Second, trade smaller positions. The number of contracts you trade depends on your bankroll and account size, but a 10-contract position in oil just one year ago entails the same risk/reward that a five-contract position does today. There’s also a mini oil contract (half the size of the standard contract) that’s more attractive for smaller trading accounts.
For Futures Market Forecaster subscribers, I’m planning to implement a new policy for specific trade recommendations. Certain markets and trades are more appropriate for a broader base of subscribers. These are the slower-moving markets or longer-term trades.
Then there are those faster-moving, higher-risk, more-volatile markets such as oil. Until now, I’ve shied away from recommending such short-term trades in markets as volatile as the current one because they’re not geared toward the majority of subscribers.
However, there are people who are able to trade short term, and they’re willing to take on additional risk for a potential quick return. Because there are now many more short-term, higher-risk, higher-potential opportunities than ever, I plan to send out special e-mail alerts for trades that meet these criteria. These special trade recommendations will be labeled separately for traders who are willing and able to trade them.
Remember, risk equals opportunity.