Where is the Price of Oil Headed?

Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The price of oil has experienced high volatility in the past couple of weeks. But despite this high volatility the price of oil remained close to its starting point from the beginning of month. Will this high volatility in the oil market continue? Further, will oil prices resume their downward trend?

During October, the price of oil fell by 0.4%; United States Oil (NYSEMKT: USO) mirrored this decline with a 0.4% drop of its own. The tensions in the Middle East may have contributed to the high volatility in the oil market, but the stable OPEC oil production, the decline in the IEA projection for global demand in 2012, and the rise in U.S oil production and refineries input curbed the rally of the price of oil. Let’s further explore these issues and determine what is next for oil prices. 

The high volatility of oil prices has affected several oil producers, including Chevron (NYSE: CVX) and Exxon Mobil (NYSE: XOM). During October, the linear correlation between Chevron and oil (daily percent changes) is 0.4, and between Exxon and oil it is 0.43. Thus, nearly 16% of Chevron’s volatility and 18% of Exxon Mobil’s volatility (under the assumptions of linearly of relation and normality of data) could be attributed to the shifts in the price of oil. The moderate fall in oil prices may have also pulled down these oil producers’ stocks. These energy companies are also strongly correlated with the S&P500 index (during October the linear correlations reached 0.56 and 0.46, respectively). Thus, the ongoing fall of the S&P500 may have also pulled down, to a certain extent, the stocks of these energy companies. Nonetheless, if the price oil will continue to dwindle it could affect the valuation of Chevron and Exxon.  So let’s see what has changed in the oil market.

Storage

Last week, the U.S. Petroleum and oil stockpiles decreased by 4.3 million barrels, reaching 1,792 million barrels. The current oil stockpiles are 22.9 million barrels above the levels during the same week in 2011. The linear correlation between the changes in stockpiles and oil prices is mid-strong and negative, which mean that if oil stockpiles fall further, it could suggest that oil prices are likely to rally.

Supply

From the supply side, according the previous EIA report, the U.S oil production continues to rally, as the average production rose last week by 4.3% (week over week). Refinery inputs also rose by 0.7%.  Based on these data, the U.S supply expanded last week, and might be among the factors to curb the rally of oil prices. This explanation seems reasonable, but the data don’t support this claim.

The chart below shows the development of the four week average oil production and the weekly average price of oil between the years 2011 and 2012. The trend between the two data sets seems to coincide, but the linear correlation between the two is roughly -0.015, which isn’t significant. Therefore, the weekly shifts in oil production aren’t enough to explain the movement of oil prices on a weekly scale. Nonetheless, if oil production rises further, it will help pull down the price of oil in the long run.

As for OPEC’s oil production, there wasn’t any sharp changes during last month. According the recent OPEC report, the total oil production only slightly declined to 31,078 thousand bbl/d in September. All eyes continue to be on Iran as its oil production remains low: its oil production reached 2,723 thousand, which is still a relatively low amount compared to previous months. This might suggest that if oil production remains low, it could eventually affect the oil market. The ongoing tensions in the Middle East and the sanctions by Europe and the U.S. against Iran raise the chances of an escalation in the Middle East that could adversely affect Iran’s oil production. 

Keep in mind that it doesn’t require a sharp drop in production for the price of oil to rise precipitately. The oil production of Libya, which before the civil war was around 1,600 thousand bbl/d – nearly half of Iran’s production – caused the price of oil to jump by more than $20 per bbl within a matter of weeks. Thus, even a 50% drop in Iran’s production could cause a sharp rise in oil prices. This raises the question--is there something to worry over?

The big question is whether the U.S., along with Israel, will commence a full blown attack on Iran. Since there is still time until the Presidential election, this question won’t be answered until then. Further, the recent decision in the Israeli parliament to have elections at the end of January also pushes the debate over an attack back untial at least after the Israeli elections. Therefore, I don’t think the oil market will be affected by the tensions in the Middle East. There could be additional speculations about the future steps of these three nations that could affect the oil price, but again I don’t think these speculations will amount to a fundamental change.

This leaves the demand side and the fluctuations in the currencies as the only factors that could have a substantial effect on the oil prices. In regards to the demand, the recent IEA report projects a decline in the growth in demand for oil in 2012. This could loosen the oil market and thus lower the price of oil.

Therefore, I think that the price of oil will continue to fall in the weeks to follow; there might be additional spurts in the price of oil as the tensions in the Middle East will remain high, but unless there is some unexpected development that is related to the oil market (e.g. an escalation in the Middle East, another Hurricane in the Gulf of Mexico, etc.), I still guess the price of oil will come down.

This analysis on oil prices was first published on Trading NRG

For further reading:

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Why Caterpillar isn’t pulling up? Just Blame it on the Oil

 

Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.


liorc has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil. Motley Fool newsletter services recommend Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.If you have questions about this post or the Fool’s blog network, click here for information.

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