Fundamentals of Crude Oil Pricing: Part V
Posted on: November 4, 2008 - Email Article - Printable Version
If you have not read parts one the earlier parts of this article, please visit Part One, Part Two, Part Three, and Part Four.
Fear and Uncertainty
Fear and uncertainty and the worst enemy of a financial market, and, if you turn on the television, it is easy to see why this is the case and how it can affect the world financial markets. Within the crude oil markets, fear and panic can cause a severe move in either direction. During this current credit crunch and liquidity crisis, we have seen crude oil drop from its peak of $147 all the way down below $80 a barrel. This drop was not based on supply and demand metrics, but on investors fearfully pulling out their remaining capital from all segments of the market. Margin calls have become even more prevalent, especially when asset prices are decreasing. This has the exact opposite effect of a short squeeze. You can read more about the affects of a short squeeze on oil in another article I have written, http://www.bullishbankers.com/why-was-crude-up-huge-on-monday/. Fear will cause crude oil to be priced irrationally and it is impossible to quantify its effects on the price even though it is blatantly apparent that it exists within the market.
Other Risks
Obviously, there are many factors that have a bearing on the price of crude oil; I would need to write for another year or two to name them all. The factors I have laid out are the most commonly talked about factors, but by no means necessarily the most important factors. One time events generally have an effect on the markets, as well as events that surface every so often. A good example of this is the potential problems and conflicts involving the Strait of Hormuz. This strategically positioned strait is located between Iran and Oman and is probably the single most important geographical location in the world in regards to crude oil pricing. Because of the vast amount of crude oil production coming from the Middle East, it is estimated that roughly ~40% of the world’s crude oil travels through this strait on a daily basis. If anything were to happen to the strait, the crude oil markets would be in complete meltdown. The realization of this threat has never been real, until recent threats from Iran’s President Mahmoud Ahmenijhad mentioning sinking Iran’s own oil tankers to block the strait in order to inflict financial pain on nations who rely heavily on crude oil. Luckily, the United States has a naval fleet stationed full-time near the strait, but that does not necessarily mean that an attack could be averted. Certain special situations such as this hypothetical scenario will generally have an upward effect on crude oil.
Final Thoughts
Obviously, the information presented above and in this set of articles is an extremely large collection of information that is only a relatively small piece of the entire puzzle. The market in many cases is fairly efficient and there are other factors priced into crude oil that no one can even begin to understand. As I have stated above, there is no set equation to determine what a barrel of crude oil is worth but I think it is very apparent that if there is an overriding factor, it is the all encompassing supply and demand equation. Even this seemingly simple concept is almost impossible to map when it comes to crude oil, and all of the other variables make the real equation unknown.
There are many great sources for information on crude oil, especially in terms of history, pricing, and how macro economics affect crude oil. If you are interested in learning more about crude oil and its rise, I would highly recommend reading the book The Prize: The Epic Quest for Oil, Money, and Power by Daniel Yergin. This Pulitzer Prize winning book is the most accurate and in-depth description of the history of crude oil as well as the macro economic ideas that are important to the past, present, and future of the commodity. The book is over 900 pages long but it is one of the best books I have ever read and for anyone invested or planning on investing heavily in energy stocks, it is a must read.
I believe that there are three important things to remember: firstly, over the short term and sometimes intermediate term, the fair value for a barrel of crude oil is what the market says it is and nothing else. Secondly, the market does not always digest information in the fashion that seems the most logical. Oftentimes, new information will surface that would seem to be bullish or bearish for crude oil and the price will react in the exact opposite manner. This may occur because there are other factors at play simultaneously: other investors do not come to the same conclusions from the same information, or for other reasons that are seemingly illogical. Finally, as much as you or I may think that we know about crude oil and its market, there is an even larger amount of information that we do not know.
- Charles W. Petredis
Disclosure: COP owns a stake in LUKOIL and the mutual fund the author manages as well as the author’s family is long COP. The author’s family is also long PBR.
The Following Stocks Were Mentioned In This Article: COP, PBR
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