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The Best Indicator That Oil Prices Will Rise -- Quickly

By Travis Hoium - Jan 26, 2015 at 12:00PM

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A peek into the market's crystal ball tells us oil prices may rise dramatically in the next two years.

No matter what the "experts" say, no one really knows whether oil prices are going higher or lower over the next year. But the invisible hand of the market is definitely making a guess that looks very bullish for energy companies and investors. 

Looking at the price of oil futures, we can get a glimpse of what traders and market participants think of oil long term and where prices will go. Maybe the plunge in oil prices won't last as long as some have predicted. 

Oh, no -- contango!
Today's oil market is in something the industry calls contango, meaning the future price of oil is higher than the current price of oil. If the opposite is true, the market is said to be in backwardation. They're strange words, but oil trading is a strange world.

Take a look at crude oil for delivery out to December 2019 and the market is clearly in contango, which means traders think the price is going to rise fairly sharply in the future. Between March 2015 and December 2016, the market thinks oil prices will rise 30.5% to $59.09. 

Source: CME Group. 

This is key right now, because traders are taking on a lot of risk by buying oil futures contracts above today's price. Essentially, they're taking the risk that oil prices will stay where they are today or even fall.

In theory, backwardation in oil is "normal" because futures buyers are taking on the risk associated with future swings in oil prices, so they should get a discount to do so. A contango market means traders are very bullish and willing to take on extra risk than normal.

High futures prices could keep oil drillers in business during 2015. Image source: LINN Energy.

Why aren't futures over $100 per barrel?
While prices are bullish, there's a limit to how high a futures contract will go versus the spot price, so we shouldn't be surprised to see futures well below the $100 that some market experts predict it will be in a year or two. That's because a market like oil still has arbitrage opportunities. If the future price of oil is high enough, you could buy oil today, store it, and sell it in the future for a profit. If you sell futures properly, you could guarantee a rate of return with little to no risk.

Fellow Fool Matt DiLallo recently wrote about how this arbitrage is already happening, with oil tankers literally sitting and holding oil that will be sold in the future for a higher price. It seems crazy, but if you're trading hundreds of millions, or billions, of dollars in oil, a guaranteed return through arbitrage can be very attractive -- even if it means renting an oil tanker.

So the market is bullish on oil prices, but even if every futures trader thinks prices are going higher, there's a limit to how high the futures prices will go. 

What this means for oil stocks
The current condition of the oil futures market may say a lot about oil investments over the next few years. Oil stocks have been crushed along with oil prices, but the market certainly thinks prices will move higher.

This serves a couple of purposes for oil companies. First, they can sell futures contracts to guarantee the price they'll get for oil a few years in the future. If they have production costs that are low enough to make $60 or $70 oil profitable, they may do this to ensure long-term survival.

The offshore drilling market may see a drop-off in 2015, but if prices rise long term, this will be a great place for investors. Image source: Seadrill.

The second thing it does is give investors confidence that the future price of oil will be high enough to ensure that producers and service companies will be profitable. Some companies will need it.

Continental Resources (CLR 1.39%) sold all of its oil futures contracts, known as hedges, in the fourth quarter, logging a $433 million one-time gain. If oil prices indeed rise over the next year, that could be a brilliant move, but if they don't, the company is left exposed to low spot prices for oil. Investors are certainly hoping the futures market is right, or it could be a bad year for Continental.  

Indirect companies will benefit if the market is right that the price of oil will rise as well. Seadrill (SDRL) stock has lost around three-quarters of its value since peaking in 2014, and that's all because investors fear the price of oil won't climb to a level necessary to make the company's bread and butter ultra-deepwater drilling profitable. Short term, the company's contracts will keep it afloat, but long term, the price of oil will drive demand for rigs and ultimately the stock. A market strongly in contango is good for investors looking into Seadrill's crystal ball.

Whether you're looking at oil explorers and producers or service companies, the price of oil is the underlying factor that will drive value for shareholders. That's why the futures market is at least worth looking at when considering energy investments. Based on what the market is predicting, the future of oil companies might not be as bleak as the present market conditions would seem to tell us.

Travis Hoium owns shares of Seadrill. The Motley Fool recommends and owns shares of Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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