Monday, December 29, 2014

Oil Prices

I come from an Oil background and the recent drop in oil prices globally has indeed affected quite a lot of players.

Brent and WTI and dropped by almost half in the last 6 months. Personally I feel that this is overdone, as fundamentally there is not THAT much of change from 6 months ago but instead a huge change in sentiments.

To start off, maybe I should explain what are these futures about. Brent and WTI and both forward contracts of oil that are deliverable at a certain place and point in time. They are typically monthly contracts, for eg. Jan 15 Brent, Mar 15 WTI etc. When people talk about oil prices, they typically refer to the nearest month's contract price.

As for bench marks, Brent is typically used as a global bench march, meaning all other oil in the rest of the world uses this as a fundamental price and start to build on it to arrive at a price where they will be consumed. For example, in Asia, crude prices are traded using a bench mark called 'Dubai', which is benchmarked against Brent. Essentially, when you are trying to value a particular crude at a certain point in time, you use the most liquid quote (Brent) and and add/subtract known differentials to arrive at the price of the actual product that you are looking to buy/sell.

WTI is rarely used as a bench mark outside of USA because the price is greatly affected by the pipelines in USA and also because WTI cannot be exported out of America. It is somewhat correlated to the crude prices outside USA, but because brent is a better correlation, WTI is seldom used.

So now back to the actual topic, these contacts are for oil prices somewhere in the future. Hence prices are a reflection of market sentiments and not actual supply/demand. The recent drop in prices have a thousand and one explanations, the favorite being the OPEC countries not wanting to budge on reducing their output so as to maintain their market share. If you think about it, I don't think such a move will justify a drop of 50% in oil prices. And if you notice how all those market reports on predicting oil prices, the analysts just keep on changing their target as the prices change. All these reports are always a look back on what has happend! and are not giving a netural and forward looking view.

Anyway, at this price level (Brent at $60), they is probably still room for the oil prices to drop. However, similar to the stock market, it is very hard to pick the bottom. I would say that it make senses to start accumulating. You can do so by buying further out oil futures (like brent Dec 15) or like United States Oil ETF in the US. One good pick I think people should look out for are oil related companies who have been hit as hard as the underlying oil price itself. I might be wrong, but I feel that oil rig builders/maintenance, will still be in business, albeit slower. If you have the patience, I think it is a good time to accumulate these companies for the dividend and capital growth.

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