My TFSA Update August 2015 - How Oil Could Go Up by 27% In Just 3 Days

Last update on Sept. 14, 2015.

Image: Speculation Sign, courtesy of Shutterstock

 

In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. In addition, I’ll explain why it was possible for oil to jump by $10/barrel in just three trading days, and I’ll discuss whether similar events can happen again.

 

August Results: Down 10.7%

At the end of August, I had $54,669 in my TFSA account, which is down by $4,901 since the end of July. However, that’s after I had contributed another $1,500 to the account, which means that my real loss was $6,401. Taking contributions into account, my TFSA account went down by 10.7% in August. By comparison, the Canadian stock market went down by roughly 4% while U.S. stocks went down by 5% in terms of Canadian dollars, so I underperformed the market again in August.

My portfolio took a beating again last month as oil stocks continued to fall. As long time readers know, the majority of my portfolio today consists of oil related stocks. Interestingly, my oil stocks went down in August despite the fact that the price of oil at the end of the month was actually higher ($49/bbl) than it was at the beginning of the month ($47/bbl). But the beginning and ending prices don’t tell the whole story.

Oil prices steadily decreased during the month, reaching $39/bbl on August 26. But during the three remaining trading days of the month, oil prices made a huge spike, ending, as noted, at $49/bbl on the last day of August. In just three days, the price of oil went up by $10/bbl, which represented a gain of 27% since its low on the 26th. This was the biggest three-day spike in oil prices since 1990.

Although my oil stocks shot higher during these last three trading days of August, they didn’t regain their losses for the month as oil itself had. However, if oil prices continue to rise in the future, it’s only a matter of time before my oil stocks catch up.

Many people have been wondering what caused the recent spike in oil prices and whether we could expect to see it again. I will devote the rest of the article to answering these questions.

 

The Role of Speculators

If you tried to find a rational explanation for oil’s dramatic rise on August 27, you would be hard pressed to find one. The U.S. government did report on Aug 26th that oil inventories went down substantially, but the markets didn’t reacted strongly at all to this news that day. Shell did close some Nigerian oil pipelines because of leaks, but the pipelines affected only a small amount of production, and for only a brief period of time - a week, as it turned out.

The truth is that there’s no “rational reason” for oil’s dramatic rise starting on the 27th. In order to understand what really happened, we first need to understand how oil markets work.

As in any other market, the price of oil is determined by supply and demand. if there are more sellers (i.e. supply) than buyers (i.e. demand) at any point in time, the price of oil goes down, and vice versa.

There are two types of buyers and sellers, and they are “commercials” and “non-commercials”. Commercials are entities like oil producers (who are the sellers) and refineries (who are the buyers). In other words, they are those entities that sell or buy oil for industrial purposes. Non-commercials represent investors who buy and sell oil purely for investment purposes.

Non-commercials are also generally referred to as “speculators”, though it’s a bit of a misnomer because commercials can speculate as well. Speculation by definition means buying (or selling) something because you expect prices to go up (or down). If a refinery locks in oil prices further into the future because it expects prices to go up, the refinery is speculating. However, only non-commercial entities (such as myself) are generally labeled speculators.

Speculation is theoretically good for markets because it tends to smooth out prices. To see how this works, imagine a scenario where no one speculated in the oil market. In this scenario, the only buyers and sellers are commercials.

Let’s say that one day the world produces 100,000 more barrels of oil than it consumes. Because there are no speculators, no one is there to buy the excess 100,000 barrels. Prices will have to adjust so that either the producers are forced to cut supply by 100,000 barrels, or buyers will have to increase their demand by 100,000 barrels, or a mix of both. Since oil supply and demand can’t change very quickly, oil prices will crash, perhaps to $20/bbl.

Conversely, when the world needs 100,000 more barrels of oil than it produces, without speculative demand, prices will have to rise to the point where buyers cut back on their planned purchases, lowering their demand. In this case, oil prices will spike, perhaps to $150/bbl.

The world can move from an oversupplied market to an undersupplied market in a very short time. For example, a terrorist attack on a major oil facility can force this transition literally overnight. But even without such events, world production fluctuates by hundreds of thousands of barrels a day from month to month as facilities go on and offline due to outages, both planned and unplanned. Without speculators then, oil prices would regularly swing between $20/bbl and $150/bbl in a matter of months or even days.

Speculators theoretically help the situation by buying low and selling high. When the world produces more oil than it needs, speculators step up to buy the excess oil in anticipation that prices will go up in the future. By buying oil during these times, speculators add to the demand for oil, which pushes prices up.

For example, speculators may buy enough oil such that prices don’t go below a threshold. When the time comes where the world needs more oil than it produces, speculators may sell the oil they bought earlier. This additional supply will ensure that prices don’t rise above a certain threshold as well.

The presence of speculators therefore ensures a more stable oil market, in theory. Whereas oil prices would have oscillated between $20/bbl and $150/bbl without speculators, they may oscillate between $60/bbl and $100/bbl with some speculators, for example. It’s possible that with more speculators, you could further narrow the trading range to between $70/bbl and $90/bbl.

 

How The Real World Works

In the real world, speculation is rarely as neat and tidy as I’ve described. Instead of transitioning smoothly, oil prices often display erratic behaviour. In the past year, oil prices fell from over $100 to $45 in a matter of months. As we saw earlier, oil prices were able to rise by $10/bbl in just three days. So why doesn’t the real world mirror theory? To see why, we need to understand how buying and selling oil futures works.

An oil future is a contract that promises delivery of oil at a future date. For example, buying a WTI future (the most commonly traded North American oil future) with a delivery month of December 2015, entitles you to receive 1,000 barrels of oil at that time.

Speculators generally use futures to bet on oil. Trading futures as opposed to physical barrels of oil has an advantage in that the speculator never has to deal with the headaches of moving and storing oil. Those who wish to bet on oil can buy futures with some time left until maturity, and swap them later for longer maturity futures. For example, speculators may buy December 2015 futures initially, but in November, they may sell the December 2015 futures and buy January 2016 futures.

Speculators wishing to bet against oil can use a similar procedure; i.e. they can sell oil contracts, and keep swapping them out for longer maturities. This makes betting against, or ‘shorting’ oil much easier than shorting stocks.

When you buy an oil future, you don’t have to put up all the money at once. Instead, you only have to put down an amount equal to the “initial margin”. For example, a single WTI future promises delivery of 1,000 barrels of oil, so buying all those barrels outright at $45/bbl would cost $45,000. However, the initial margin is just $5,040, which means that someone who wishes to buy the contract only needs to put down $5,040.

Once the investor enters into a contract, the investor will be required to maintain a certain amount of value in his or her account. The amount that’s required is called the “maintenance margin”, which as of the time of this writing is about $4,500. Let me show you how this works.

Suppose that an investor puts $6,000 down to enter into a WTI contract when the oil price is $45/bbl (i.e. $45,000 worth of oil). Let’s say that oil prices drop by $2/bbl, so the value of the investor’s account drops by $2,000 to $4,000. Since $4,000 is less than $4,500, the investor will either be forced to put up more money or to sell the contract.

Unfortunately, this structure lends itself to boom and bust cycles in oil prices. As oil prices go down, some investors may be forced to put up more money or to sell their contracts. Some of those investors may opt to sell, which may result in lower prices, forcing yet others to either put up money or sell their contracts.

This sustained downward trend in oil prices can hurt investors in other ways. Some of the largest investors in the oil market are hedge funds that manage other people’s money. As oil prices go down, the performance of those hedge funds suffer, which often leads some of their clients to withdraw money from the fund. Such withdrawals hurt the ability of those funds to put up more cash and keep their oil futures. When the funds are unable to put up more cash, the funds “blow up”, as they’re forced to sell their futures. Such blow ups often lead to sharp falls in oil prices.

Furthermore, there are many investors who make it their business to try to sniff out whether these funds are close to blowing up. When these investors sense weakness, they make heavy bets against oil. These bets push prices down and often end up triggering such blow ups.

I believe that this is, in fact, what has happened over the last few months as oil prices crashed again from $60 at the end of June to $39 on August 26. Several hedge funds that invested in oil closed shop as their clients withdrew money. On the other hand, bets against oil surged to record highs.

The vicious cycle that resulted in oil prices going lower and lower can also cause the price to go in the opposite direction, and for exactly the same reason. As oil prices go up, those who bet against oil by selling futures either have to put up more cash, or buy the contracts back. When many of these investors buy the contracts back at the same time, the result is a big spike in oil prices. This process is called “short covering”.

Unsurprisingly, the oil market is more likely to experience short covering when there are a lot of investors who are betting against oil at the same time. As oil prices surge, there is an increased chance in this environment that more investors will have to buy back the oil futures.

In August, the amount of speculative bets against oil in the U.S. rose to a record 163 million barrels. This amounted to roughly one third of all commercial oil inventories in the U.S.

As oil prices started to surge on August 27, a stampede erupted among those who had bet against oil to buy back oil futures. This went on for three trading days, as the surge in prices kept blowing up more and more of these investors. As a result, the number of bets against oil was reduced to 136 million barrels in a week, a decrease of some 27 million barrels.

While the number of bets against oil had fallen substantially during that week, the number of bets still remain near record highs. This makes it possible that we will see further short coverings in the days and months ahead, though we should also keep in mind that future oil price crashes are always possible as well.

As you read what really happens inside the oil market, you may have noticed that I haven’t mentioned the oil fundamentals (i.e. global supply/demand) even once. Indeed, speculators play games with the markets to such an extent that fundamentals almost don’t matter in the short run. This is how it was possible for oil to go down to as low as $39/bbl, even though an ounce of rational thinking would make one conclude that oil prices should be much higher in the long run.

Many people, upon realizing how speculators cause such irrationally low (or high) prices, tend to become angry with them for pushing prices to such extremes. However, as value investors, we should thank them instead. Without the speculators playing such games, we would never be able to buy oil or oil related stocks at such huge discounts.

Notes:

Initial margin shouldn’t be confused with borrowing money on ‘margin’ through your brokerage account, as their meanings are unrelated.

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