The oil market seems to have lost a little bit of its crazy lately. Since 2007, it seems that every week there's a new panic or a price pop or plunge. But since the sun rose in 2012, there seems to be some calm in the market.
What in the world is going on? Is the oil market becoming more rational?
International forces matter
The most recent spike in the price of oil was due to concern over the impact of sanctions on Iran and the subsequent saber rattling. A jump in prices when nothing has happened may seem crazy to you, but it's perfectly reasonable in the oil market. To oversimplify, oil trades based on two things: the current supply and demand of oil and the future anticipated price, driven by the future supply and demand of oil.
If current prices are low relative to future price, a big oil buyer could buy oil in the spot market, sell futures contracts, rent a tanker, store oil for a few months, and then sell it at the higher future price. There are formulas that tell traders the upper and lower limits a contract must have compared to another.
If traders and companies think there's a reasonable chance oil production will be disrupted six months out, the futures price rises, and so does the spot price. A look at the current futures contracts shows that oil is expected to rise slightly until 2013, when the market anticipates a decline in price.
The bottom line is that the reaction to Iran was rational -- and short-lived, as nothing has happened. Prices have fallen in the last month and a half, when supply and demand took over.
Supply and demand mean something
The oil headlines have been remarkably rational in recent months, too. On April 8, Reuters' headline read, "Oil falls as U.S. stockpiles hit 9-month high." Supply up, price down -- that's the way this is supposed to work. Yeah! One point for rational markets!
The increase in supply has also coincided with a big rise in oil and gas prices over the last few months. As headlines talked about constantly rising prices and predicted $5 per gallon gasoline, consumers cut back on consumption. Demand reacted to price.
We may also point to a rather sharp decline in the usage of petroleum products, even as the economic recovery takes hold. New efficiency standards for automobiles are forcing Ford (NYSE: F), General Motors (NYSE: GM), and Toyota to increase efficiency, leading to a reduction in consumption, even if driving habits don't change. Combine a small improvement in efficiency and a small change in driving habits due to high prices, and you have a big change in demand, capping the spike we saw in prices early in 2012.
Speculators haven't been, and won't be, the problem
Whenever I write about the oil market, there are invariably comments blaming speculators for the price of oil.
Believe it or not, oil speculators play an important role in the oil market, and they're not responsible for rising prices, least of all in the long term. They trade futures contracts that help the market determine what the "correct" price oil should be. In the short term, the trading can get crazy, but in the long run they're here for price discovery -- not to manipulate the market. They're easy to blame when the price of oil rises, but if they couldn't find a buyer for their contracts when they expires, they would have to take deliveries of oil -- something traders do not want to do.
This price discovery helps companies plan production and exploration. If oil is $100 per barrel today but trades for $50 a barrel in six months, it would be highly risky for me to drill a well that's expected to begin production in six months. But if I can lock in a price, I reduce business risk.
Bakken shale drillers such as Kodiak Oil & Gas (NYSE: KOG), Continental Resources (NYSE: CLR), and Whiting Petroleum (NYSE: WLL) -- three of the companies contributing to a dramatic decline in oil imports -- all use futures and other derivatives to reduce business risk when expanding drilling in the United States. Without these markets, they wouldn't be able to plan new investments and predict cash flows.
Rationality is here for now
Oil is settling in at a comfortable price of about $100 per barrel, and it looks like it will take a lot to move it from that spot. And there are plays that could see soaring profits with oil prices at $100 or more! For three stock picks that you need to know, click on our free report here.
