There are numerous factors that influence the price of oil. The one we are all familiar with from Econ 101 is supply and demand. For West Texas Intermediate, this is the measure of supply at Cushing, Oklahoma vs. the estimated measure of demand. The price of WTI generally rises when there is a draw down in stocks at Cushing, and falls when there is a rise in stocks relative to demand.
Although impossible to predict, there are key indicators of the oil market’s price direction. One of these is the Commitment of Traders Report, which provides a weekly breakdown of open interest in the futures markets.
Futures trading in the United States began with the grain markets. Farmers would bring their grains to fixed points in the Midwest, such as Minneapolis (MGEX), Kansas City (KCBT) and Chicago (CBOT) to sell their products for either immediate delivery (spot/cash market) or forward delivery. These forward delivery contracts, or futures, are now standardized and traded on exchanges.
The West Texas Intermediate contract is traded on the New York Mercantile Exchange (NYMEX). Each WTI contract represents 1,000 U. S. barrels of oil (42,000 gallons). The tick size, or minimum price movement per contract is .01, at a value of $10.00 per one-cent move.
A recent conversation with a very successful oil and gas producer had some surprising results. He replied, “I manage risk ” to the question “what do you do.” Futures contracts are one of his risk management vehicles.
An oil and gas producer is always “long” the physical crude market. She wants to sell her oil for the highest price. Obviously, a high price is not always possible due to extreme fluctuations in the price of oil. To best manage risk, a producer (hedger) will sell forward contracts (futures) to speculators in order to lock in a price and bank a certain amount of profit. This enables the producer to better service debt, manage payroll, and generally have a sound financial baseline for her operations. The speculator takes on this risk in order to benefit from favorable price movement.
Commitment of Traders Report (COT)
The COT Report provides a breakdown of the open interest in which 20 or more traders hold positions equal to or greater than the reporting levels set by the Commodity Futures Trading Commission. Open interests are the total of all futures contracts entered into but not yet offset by a transaction, meaning the buyer has yet to sell, or the short seller has yet to buy. The COT Report is split into three categories: commercials (producers/merchants, etc.), large speculators (hedge funds, managed money, etc.) and small speculators (average schmoes like you and me).
Many traders believe the commercial trader activity is the best yardstick for the true value of a commodity and to determine market direction. An examination of the COT Report in 2016 versus price of WTI reveals that as prices bottomed at $32.22 in January, large speculators began to buy while commercial traders continued their trend of reduced action (see chart below). The large speculators’ buying boosted the price of WTI to a high of $52.28 on June 9.
(Large Speculators = Green, top line; Commercial Traders = Red, bottom line)
Unfortunately, the chart also shows that large speculators stopped buying and began closing their positions in mid June. At the same time, commercial traders used the speculative increase in price to lock in windfall profits by selling contracts at or near the high of $52.22. As of this writing, the selling by commercial traders continues to increase while the selling/inactivity of large speculators also increases. When everyone is selling, price goes down. This takes us back to Econ 101: supply vs. demand.
Only time will tell if this current slump in prices down from $52.28 to around $45.00 a barrel will continue. The next few months will determine whether or not the large speculators can continue the rally began in mid-January. Being an optimist, I believe in the industry and see higher prices ahead. When that will happen, however, is the billion-dollar question.