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Trading Lessons

Why Crude Oil Prices Are Entering a "New Normal"

Commodities / Crude Oil Oct 03, 2012 - 07:40 AM GMT

By: Money_Morning

Commodities

Best Financial Markets Analysis ArticleDr. Kent Moors writes: One of the things I have learned from almost four decades of doing this is that oil and gas specialists know a great deal about what they do for a living.

However, few of these specialists really understand enough about what the person to the right or left of them does. This tends to breed tunnel vision.


And these days it has become a serious problem.

That's because what is now hitting the oil and gas markets requires a more expansive and integrative understanding of what is actually taking place.

The truth is energy markets are evolving.

We are entering a period in energy and oil prices that I have begun calling the "New Normal."

You see, a volatile, dynamically changing combination of factors now undermines the traditional way of viewing oil and gas markets.

And it is about to get a whole lot more unnerving for the average analyst who still insists on pushing square pegs into round holes.

Unfortunately, for the old school aficionado, we are rapidly moving into new territory. Here, market machinations are occurring that defy the "traditional" explanations.

Oil Prices and the Talking Heads
You know what I mean by "traditional."

The talking heads on television try to explain the latest spurt or dive in oil prices by relying on the same trite and tired lineage of explanations.

In just the last month, we've seen movements in energy prices justified solely on the following factors:

•A supply glut in Cushing, Okla.;
•Fluctuations in the euro-dollar exchange rate;
•The European credit crunch;
•The latest unemployment figures;
•Inflation;
•Manufacturing, housing, or production figures.

But it really doesn't work this way anymore. While such factors are not completely irrelevant, they are also not calling the shots.

There are several factors contributing to this New Normal, but I will be restricting my comments this morning to just three.

They are:

1.The balance between conventional and unconventional production;
2.Increased market volatility; and
3.Global geopolitical matters.
So let's get started.

Unconventional Production is on the Rise
The rise of shale and tight gas and oil, coal bed methane, heavy oil, bitumen, and synthetic (upgraded) volume from oil sands has fundamentally changed the production landscape.

But it has also fundamentally altered the dynamics upon which pricing is determined.

Initially, most of us assumed that these unconventional sources would serve to restrain price, as more supply came online to meet rising global demand.

The reality, however, appears to be that this new largess is becoming more expensive to produce, transport, and process, while the distribution of the shale, sandstone, or in situ hydrocarbons are rendering basin projections less reliable.

There is more available, but the cost of production and the price commanded on the market are creating short-term aberrations with attendant risks and opportunities.

One thing it has done is temper the Peak Oil approach.

Over 50 years ago in an address here in this city of the Alamo, Shell scientist M.K. Hubbert kicked off the movement with one of the most famous presentations in the history of petroleum analysis.

Today, it is not availability, but where it is available and at what price that is making all the difference. The balance between conventional and unconventional, therefore, is making an impact but hardly all in the same direction.

Volatility with a Capital "V"
The second factor - volatility - is no stranger to regular readers of Oil & Energy Investor.

This is not simply quick rises or falls in price, although these are the clearest impressions left.

The Oil VIX is supposed to register volatility, and a "traditionally normal" market would expect that the OIL VIX would rise (as risk rises) in parallel with a fall in oil prices.

That often no longer happens.

The volatility now experienced is occurring within the average range of VIX figures.

Stated simply, our new volatility is providing cycles occurring more rapidly than the session averages provided by the VIX. The traditional way of expressing what volatility means in the oil and gas markets no longer helps us in compensating for changes in investment patterns.

Such volatility also translates into how futures contracts on oil and gas determine current market prices. It used to be that, as we moved closer to the expiration of a futures contract - as the convergence between the paper barrel (the futures contract) and the wet barrel (the actual consignment of crude or natural gas) approaches, the two would merge into the same underlying price.

Often, that would make it necessary to buy on one side or the other to produce the desired equivalence. But such arbitrage was easily done, and the market was better off because of it.

Not anymore.

As I indicated in my last book (The Vega Factor: Oil Volatility and the Next Global Crisis), this is not usually a result of speculators or manipulations by companies, distributors, or mega investment funds.

Rather, the inability to connect the future contract with the actual price of the oil or gas results from problems within the trading system itself. This volatility has produced the rise of a whole new generation of derivatives, itself a clear sign that the market is not coping with rapid change.

Global Tensions Heat Up Oil Prices
Third is the geopolitical factor.

Now international events have always had an impact on oil prices. The current climate, on the other hand, has given the factor new urgency.

It is the reason I have been spending much time lately dealing with the Iranian crisis and the prospects of Iraqi production. Flash points in the region upon which the global market still depends for the brunt of its conventional oil are weighing heavily on our ability to estimate supply and price.

Most observers still regard these considerations as exceptions to some general textbook rule of market practice.

Sorry, this is not the case.

As I indicated last week when writing from my briefings in London, the closer one gets to the crisis centers, the more analysts recognize the longer-term implications of the geopolitical.

None of these new factors is going anywhere anytime soon. They are central parts of the New Normal.

Investors should become used to dealing with them.

Source :http://moneymorning.com/2012/10/03/why-oil-prices-are-entering-a-new-normal/

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