Saturday, January 16, 2016

Connection Between Oil Prices and the State of the Economy - My Perspective

My philosophy is to stay market direction agnostic at all times. I do not pretend to have powers to forecast and predict the flow of future events. I think, it is hard to understand the current state of affairs in the complex system of markets that I just don't see any point in having to try to predict the future and then act upon my predictions.

My view is that, as a trader or an investor, I just have to try to position my trades so that I can benefit from both falling prices and rising prices. That's a fiduciary duty, so to speak to my family, my investors and myself. Trading is tough, and there is no time for complacency, and bitching about things that didn't (or don’t) work. So one has to stay alert at all times.

Now, let's come to the core point of my article. Lately, one of the hottest topics in the news, mainly in the business news, was the state of the economy around the world. The other topic, which is no less popular is the falling prices for energy sources, mainly oil (crude and WTI). So-called experts on TV, often mix aforementioned topics with each other, to conclude that low prices for energy sources directly linked with the weakness of economies around the world. I don't quite agree with this thesis.

Major reason for low prices of oil, is the absence of demand or/and excess of supply. This is the fundamental rule of economics. Next, let’s talk about demand.

Can we categorically state that low level of demand indicates weak economic stance? Might there be other, underlying reasons for oil prices to fall. In my view, we should talk about the nature of demand and explore possible reasons for falling price of oil.

Let's try to dissect the nature of demand:

China has traditionally been a huge consumer of oil. So the real question is why China has stopped consuming certain amount of oil. The answer might be that businesses started consuming less oil, or because they became more productive and more efficient in using oil as a raw material. The other reason might be that China has started to rely on its own production of oil. As we all know, one of the policy measure that Chinese government is trying to push is the use of own raw materials and stop relying on imports.

Historically, China has been deploying protectionist policies in other types of raw materials from to time. In 2011, Chinese regulatory agencies placed a ban on exporting rare earth metals, which led to a temporary distortion in the world markets. Many consumer electronics companies rely heavily in Chinese exports, so many had to adapt to new market rules. Therefore, it is safe to say, that Chinese are trying to become more self-sustainable in its use of energy sources.

We all know that there are exporters and importers of oil. Oil is being traded around the world, on major exchanges. The price of oil is actually a price of a futures contract for a barrel of oil, with an expiration or delivery date of 3 months out. Initially futures were meant to use by oil exporters and importers to hedge their risks, of low and high prices respectively. However, now the oil markets are open for everyone to speculate on. Nowadays, the oil traders (the specialized firms that help producers to sell their products) trade mainly oil (of various sorts) for physical delivery. The last point is very important, as it shows that a certain body or agency, or cartel is not setting oil prices. Players of the market set the prices. Supply and demand in the markets for oil regulates the prices for oil futures.

Then, a keen observer from the outside might ask: What are the motivations for players in the oil market to sell or buy the commodity? This is an excellent question. The answer to this question will partly give us a clearer picture of the nature of prices of oil.

Market participants react to various statistical data. From the supply side, it’s the amount of produced oil in various countries, that has major market shares. One example of such a country, or in this case organization is OPEC (cartel). Traditionally, the OPEC countries satisfies the supply side of oil for about 30-40% of the total amount of produced oil. The news might come that OPEC countries have increased their production. This news is bearish for oil prices in general, if the demand is staying the same from the countries that has tradionally been consuming majority of oil produced. One such country is China. China as a whole has been consuming majority of oil produced around the world. Therefore, in our example, if wee that supply from OPEC has increased while demand from China is staying the same, then we might deduce that market participants will push price for oil lower. In our real case, the supply side grew their production with a ever increasing speed, while demand side dropped. China has been consuming less and less oil. All the other economies that used to be buyers of oil, now has stopped their procurement.

The founder of IBM, Tom Watson Sr., once uttered this:  "I am no genius, I am smart in spots, but I stay around those spots". Similar to Tom Watson's thinking, I also try to stick around the areas that I consider myself more or less knowledgeable, and that is trading/investing. I am not an economist, but I have my own opinions. But, what makes me different, is that I use my judgments in my trading/investing activities, so if I am wrong I lose money, if I am right I make money. I personally take risk with my own money. Many talking heads on TV do not have any personal responsibilities, as they are just “talkers”, which is unfortunate.

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