Crude Oil Hits Record High – Are Energies Too High?
by Matt Krupski
Crude oil for June delivery jumped to a new record high, above $122 on Tuesday, May 6, 2008. The spike in price was spurred by supply disruptions in Nigeria and growing demand from India and China. It also didn’t help that a new prediction was made by Goldman Sachs forecasting prices to rise to $150 to $200 within two years. Are these prices justified in crude and other energy markets?
Naturally, supply and demand are the two main driving forces behind every market. Let’s look at how these fundamentals are affecting crude oil and various other energy markets. Specifically, we’ll look at the following markets: crude oil, RBOB (unleaded gas), heating oil (distillates) and natural gas. We’ll start by looking at supply numbers that are readily available from the Energy Information Administration (EIA), a part of the U.S. Department of Energy.
The graph below shows crude oil stocks over time. The big blue bar you see there is the five-year average. The orange bar is this year’s current range. You can see that we are right about average, based on the last five-years. As you can see, producers tend to build stocks in the spring and then draw them down into the winter. Currently, we’re on the upswing with stocks being built again.
If you look at the graph below, you’ll notice there was a huge build in U.S. gasoline stocks over the winter. Part of this build up came from slightly less demand in the U.S. due to the high prices. However, over the last month those stocks have been depleted very quickly. Some of the reasons gasoline stocks have been lower include refineries being down because of maintenance or disruptions. Currently, we are taking out more than we are putting in at this point. The question then becomes, if we’ve had higher than average stocks of gasoline, why are gasoline prices at an all-time high? We’ll analyze this very soon.
The graph below shows that U.S. distillate stocks are on the lower end of the five-year average. This is the reason why the market has seen all-time highs in heating oil and diesel fuel. The market is pretty tight in terms in terms of supply compared to the historical average.
The graph below shows natural gas stocks over time. Again, the blue area is the five-year average and the red line is where the stocks are currently. You can see that the stocks are pretty much average. Natural gas is used for heating so the supplies are typically drawn down during the cold months and built up during the warm months.
The market has seen a dramatic rise in the price of crude oil. In six years, the price of crude oil has risen from $20 a barrel to $120 a barrel. We’ve already looked at supply, noticing that it is about average, so it isn’t supply problems the market is having. In my opinion, crude oil is being driven by two other fundamental factors.
The first main factor is international demand. China and India are continuing to grow extremely fast. Their economies are demanding more crude oil to continue fueling their industries. And as people’s conditions improve, they are driving more, thus adding more demand than ever.
The next main factor pushing crude oil higher is the U.S. dollar. Look at the two charts below (U.S. Dollar Index Futures vs. Crude Oil Futures). They are almost the inverse of each other. Since crude oil is priced in dollars, as the dollar weakens, it becomes more attractive to people holding foreign currencies. They are able to buy more at the same price. The weakening dollar contributes greatly to the price of crude oil.
U.S. Dollar Index vs. Crude Oil
Consequently, crude oil drives the prices of heating oil and gasoline prices. Remember we looked at U.S. gasoline stocks and noticed the supply was much more than average. This leads us to question why RBOB (unleaded gas) prices are at all-time highs. This question is answered simply by the price of crude oil. RBOB gasoline is a by-product of crude oil.
The majority of the cost in gasoline is based on the price of crude oil. Therefore, a rise in the price of crude oil leads to a rise in the price of RBOB. The charts below show a side-by-side comparison of RBOB gasoline futures and crude oil futures. You’ll notice they are both at record levels.
RBOB vs. Crude Oil
Heating oil is behaving in a very similar manner because it is also a by-product of crude oil. However, natural gas is not behaving exactly the same way in terms of price (see charts below).
There are a few reasons why natural gas is not following in lock-step with crude oil. First of all, crude oil is a lot easier to transport than natural gas. With natural gas there are problems with storage, transportation. Basically, it’s more difficult to move.
Another reason natural gas doesn’t always follow crude oil is because domestic firms eventually reach an economic breaking point where it makes sense for them to use an alternative to crude oil, such as natural gas, to power their industries.
To trade these energy markets, you need to have a stomach for the risk. I think natural gas prices will eventually catch up to crude oil. I would recommend positioning yourself on the long side of natural gas, or by conducting a spread in these markets.
Going into the summer driving season, we should see demand naturally pick up, but I don’t think it will be as strong as usual because of the high crude oil prices. Keep an eye out for the weekly supply numbers from the EIA and the movement in the U.S. dollar which has a dramatic impact on the price of crude oil. Please feel free to call me for more specific trading strategies based on your individual risk-tolerance.
Matt Krupski is a Senior Market Strategist with Lind Plus. He can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
