Oil Prices and Supplies

The crude oil market is the largest commodity market in the world. Total world consumption equals around 70-80 million barrels a day of which the United States consumes approximately 25 percent. That's right: we burn one out of four barrels produced, even though we have less than 5% of the world's population. Several times total consumption is traded daily on crude oil, spot, futures and over-the-counter markets at exchanges in New York (NYMEX) and London (IPE).

As most of you know, the price of crude oil soared on Wednesday, August 18th to over $49 a barrel. This is trumpeted as the highest oil price ever, but even a moment's reflection shows this is not true. Oil prices soared to $35 and over several times back in the 1980s, when the dollar was worth a whole lot more than it is today. So the truth is that in terms of adjusted dollars, oil has been much higher.

However, oil prices exerted a terrible influence on the stock market in the 1970s and 1980s and are now doing so again. Crude prices could spike even higher, but may well pull back in the short term (the next few weeks). Some have speculated that crude oil prices could hit $100/barrel in one to two years if events fall into place just right (or from our perspective, just wrong).

A couple of factors are driving oil prices, and they aren't going away any time soon. The first is the continuing increase in worldwide demand for oil. America is the world's number one oil hog, but many countries are scrambling to catch up. China, Vietnam and many other Third World countries, particularly in Asia, are rapidly industrializing and their citizens are buying cars in ever-increasing numbers.

This is no place for a "green" lecture and I'm not in the mood for one, anyway, but the failure to develop alternative energy sources is leading us and the rest of the world to a crunch of enormous proportions. There is an end to petroleum - neither you nor I know exactly where it will come, but it is coming. Only the dizziest optimists believe that oil supplies are never-ending. Experts are increasingly predicting a crash in the world economy by 2025 as our oil dependence increases and oil supplies continue to shrink. In the next few years, alternative-energy companies (solar, hydrogen fuel cell and many others) will become some of the hottest public companies.

The other force driving prices is organized terrorism in the Middle East. Destroying oil production in Iraq and other producer countries, which will drive up crude prices, is seen by terrorists as a highly desirable goal. Recently, Shiite militants attacked an oil facility in Basra, Iraq, and destroyed offices and other facilities. And they aren't even the real terrorists! The fear of terrorism's effects on oil prices probably will be worse than the effects themselves are, but these fears are in part driving crude prices.

Political unrest in Venezuela, the number 5 oil-producing country, contributed to concerns about oil earlier this year. Whether you are personally nervous about al-Qaeda and terrorism, accept the fact that the world markets are very jittery. Interestingly, many traders believe that oil future prices would drop significantly if bin Laden were caught, even if only temporarily.

While some want to believe that oil concerns will ease medium term and that crude prices will fall below $20 again, don't count on it.

Economic Effects of Oil Prices

Oil is used for so many things, I couldn't even list them all in this article. From petroleum we primarily make gasoline and diesel fuels, heating oil, fuel oil that is burned to generate electricity for a large part of Earth's population, greases and lubricants, and of course, plastics of all kinds. And this list is just the tip of the iceberg, although they account for the majority of petroleum used. Now of all these uses, ask yourself which ones are seeing a decline in demand or production. The answer is NONE.

Demand is increasing for everything I can think of that we make from petroleum. Naturally, increases in petroleum prices have an effect on the economy, and thus indirectly on consumers, but increases also affect consumers directly.

When prices go up, prices at the pump soon follow, sometimes almost immediately. Let's say you are an oil refiner and you have stocks of $30/barrel oil on hand. Then oil starts moving up and the price increases to $40. You don't sharply raise prices instantly, but the oil you buy to replace stocks as they are used up will cost you more. So you increase the wholesale prices to distributors, which quickly translates to higher prices at the pump. You buy oil futures to hedge against price increases, of course. Petroleum industry players are always buying and selling crude oil futures. Most traders buy and sell oil contracts like any other security.

But if you are a refiner or in any business where you need the oil, you are looking for actual delivery of the oil. So the refiner is always using oil futures to hedge. But hedging does a limited amount of good where prices go up and stay up. Put differently, when oil prices went to $40/bbl. you weren't paying that much because you had already bought oil futures as $33, $35 and so on. But at some point the cheaper futures contracts expire, and you do pay $40 and then more than $40. As your cost of crude goes up, you keep raising wholesale prices of the petroleum products you make, and each increase raises prices at the  gas pump. Gas prices are high because oil prices are high. And prices at the pump go up when oil goes up, a lot faster than pump prices come down when crude goes down.

Higher prices at the pump hurt individuals (and SUV sales) directly, since more money out of the budget for gasoline means less money to spend on burgers, WalMart and so on. But the indirect effect on consumers is also pronounced. Businesses pay higher prices for gas products, also. Prices in stores increase as it costs more to ship the goods. It is a spiral, and everyone in the chain of production and the chain of retail sales increases prices. Shippers and airlines typically pass energy-price increases on to consumers in the form of fuel surcharges.

If oil prices continue upward and remain high for a long period, energy-dependent businesses inevitably will suffer. Transportation (trucking, airlines, overnight couriers, etc.) is the most vulnerable, and auto companies can expect a drop in sales of gas guzzling models. Money spent by consumers on oil is not spent on other goods and services, obviously. That squeezes profits and sales on a host of businesses.

Higher oil prices essentially act as a tax, slowing economic growth.

Oil and the Stock Markets

As mentioned earlier, the general rule has been that increased oil prices drive the stock markets down. This is the conventional wisdom. But is it true? (Yes...) I want to point out a very interesting paper entitled Striking Oil: Another Puzzle, issued in November of 2003 by the Rotterdam School of Economics. The authors point out that, prior to the 1970s oil prices remained stable throughout most of the twentieth century, due to a combination of production and price controls by the "Seven Sisters," which were the largest oil companies in the world.

This price control came unglued by the Yom Kippur War in 1973, when control of world petroleum production and prices shifted to OPEC. At that point, oil prices began behaving like the prices of other commodities. The following graph of petroleum prices says it all. Shown are West Texas Intermediate Oil Prices from 1947 to 2003, in US dollars per barrel.

     Source: Global Financial Data Inc.

Look at that chart move around after 1973. It's like what happened after the preacher's kid was let loose in Sinville. But remember, oil is not just any commodity. It is THE commodity.

The Striking Oil paper set out to address the question whether oil prices might forecast future stock market returns. Basing their conclusions on stock market data of 48 countries, a world market index and price series of several types of oil, the authors concluded that oil prices do indeed forecast stock market returns, stating that, "We find that changes in oil prices strongly predict future stock market returns in many countries in the world... The impact of this predictability on stock returns tends to be large."

The authors also noted that "Stock returns tend to be lower after oil price increases and higher if the oil price falls in the previous month." For the developed markets the study found that the change in oil price significantly predicts future market returns in 12 of the 18 developed markets. In all countries the effect is negative. That is, a decrease in this month’s oil price on average indicates a higher stock market return next month.

The impact of changes in the oil price on stock returns tends to be large. For instance, a decrease of the oil price of 10% in the U.S. will double the expected return on the stock market in the following month. This oil effect is also significantly present in the world market index.

In other words, the stock market tends to move in the opposite direction to oil prices. Oil up, stocks down. Oil down, stocks up. This is a one-way street, however; stock market returns do not drive crude oil prices. So you can expect oil to be the primary force driving the stock markets until further notice.

But the effects of oil prices are more subtle than that. All sectors are not affected equally, or at the same time. Here is what the authors found as to U.S. sectors when oil prices rise:

• Most negatively influenced: Cyclical Services.
• Next most negatively influenced: Cyclical Consumer Goods.
• Third most negatively influenced: Financials.

Cyclical Services includes general retailers, support services, leisure and hotels, entertainment and media, and transport. Cyclical Consumer Goods include household goods and textiles, automobiles and parts. Financials are investment companies, banks, specialty and other finance, life assurance, insurance, real estate.

Consumer discretionary spending takes a hit quickly as oil prices translate to higher pump prices (and higher prices for fuel oil, etc.). Correspondingly, notice how general retail, leisure and hotels, travel and entertainment are the first hit by higher oil prices. Today American consumers are carrying record levels of debt, while savings levels are low. Incomes are being eroded year by year, which higher oil prices only exacerbate, so consumers are highly vulnerable to higher oil prices. Like I said,, it's essentially another tax.

Now, let's talk market valuation

Now let's factor in current market valuations. Over the decades, the long-term historical average of the Standard & Poors P/E (stock price to earnings) ratio has been approximately 15, meaning that stocks over time have on average traded at 15 times earnings. The current P/E ratio based on trailing earnings is 30. So compared to historical averages, the market is highly overvalued.

Before you pooh-pooh this notion as more sky-is-falling hand wringing, remember that in late 1999 and early 2000, many market mavens were ridiculing warnings that the market was overvalued. What is value, really, they asked. A couple even suggested that P/E valuations were historical artifacts and no longer very relevant. Then the bubble popped.

Why is the market overvalued? Valuation is not an abstractionl it is a pretty concrete thing. The high valuations tell us not that stock prices are too high, but that prices are too high in light of corporate earnings. So we have an overvalued market (at least compared to the historical average), a stuttering economy that continues to disappoint and very high oil prices.

What could drive petroleum prices back down - and stimulate the markets? Either an increase in production, or a drop in demand. But demand is increasing, pardner, and fast. On the other hand, OPEC is producing pretty much all it can, so there is no windfall supply of oil to be expected that can drive down prices. I'm not expecting crude to get much cheaper in the medium term.

Having said that, even a 10-15% decrease in oil prices would stimulate the markets. Who knows? While other factors influence the markets, oil prices are a major stimulant or retardant.

Evaluating the current stock market

I would dearly love to tell you what oil prices, and the stock market, will do over the next year. But my crystal ball is no better than yours. The key is not figuring out where the market is going, but to trade in light of the prevailing trend. So let's put our heads together and figure out what the trend is.

The market has since May 2004 been in a steady downtrend, but a downtrend with a large rolling motion - a lot of amplitude. On the Dow Jones Industrial Averages (INDU), price has now fought its way back to the trend line. The following chart illustrates my point:

Note the upper and lower trend lines bounding the market's downtrend since May. The market found support at Points A, B and C. By the same token, the trend line acted as resistance at Points D, E, F, G and H. At Point G the market tried hard for most of June to break out of the downtrend into a trading range, but lacked the energy and fell back to the trend line, then back below it. Now the market is back testing the upper trendline at Point I. Don't get too excited right this minute, since there has only been one close above the trend line at Point I.

Will the market break through now and establish a new trading pattern? By this, I mean will it break through the upper trendline (breaking out of the downtrend) into a ranging market? It's too early to tell, but its action at Point G is instructive. Looking at a daily, weekly or monthly chart, the trend is down. I think a ranging market is the most we can hope for any time soon. And even that will require a fair number of closes above the upper trend line, with strong volume, which we haven't seen in a while.

None of the above observations about oil prices, the economy or valuations provide any sunshine.

Thoughts on handling this market

Does this mean you cannot write covered calls in this market or trade this market? Of course not. You can successfully write covered calls in all but strong downtrends. CallWriter teaches this point as a core part of its trading strategy. Those of you concerned about the market's direction and fearful of a large correction should write all covered calls at the money (ATM) or well in the money (ITM). Stick to larger, more liquid stocks and get lots of protection when you write. If the market is really dropping when you are considering a trade (as it did on the above chart from D to A or F to C), either write deeply in the money or don't write covered calls. Remember, you don't have to trade.

But remember also, that trend lines act as support and resistance points! Our preference is to let the market find support and write off the bounce. To illustrate bounce writing, note how the market made strong moves up from Points B and C! At those points you could have written almost any decent stock out of the money and made money on the trade. I mentioned amplitude above, which is the height of each wave from trough to crest. On downtrends with large amplitude, like the current market has, there are great opportunities to trade the troughs and crests. Here's how:

Bounces: One you are satisfied the market has indeed found support, write out-of-the-money or at-the-money covered calls, write naked puts or simply buy calls, depending on your taste and your account approval level.

Pullbacks: Once satisfied that the market has hit resistance and is pulling back, write naked calls or buy puts. A pullback really is not the place to write covered calls unless the price down leg is gentle to moderate and you are writing deeply in the money.

In writing troughs or crests, however, you have to be able to see the trend. For this reason, it would have been much more comforting, and safer, to write off of the bounce at Point C than Point B on the above INDU chart. (Why? Because Point C confirmed the trend that A and B actually established.)

Traders in the stock and option markets should not position themselves at this point based on what oil may or may not do. Future oil price moves and their effects on the market from month to month are unknown and impossible to game. Instead, figure on this flaky market to continue. But cheer up! As the above trading observations make clear, there is always a way to make money. You just have to trade in a way that takes advantage of the trend.

This article is over-simplified, for which I apologize. There is no way to exhaustively cover the topic of the "oil effect" in this space, but those of you looking for the bigger picture hopefully have a better feel now for how oil prices, the economy and the stock market work together. Keep in mind, though, that oil prices are just one input to the markets. Other factors can cause markets to move up or down.

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