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Oil at $43 Trading implications

Two weeks ago a friends were telling me that they were thinking in investing in the oil market -- either via derivatives or investing in service companies -- because "Oil is going up".  That's when oil prices were around US$50/bbl for WTI.  Today oil prices have crashed -- they've been on a downward spiral for a few days now, there was a miss read of the market and draw downs of strategic reserves -- which were not that much anyway.

Still oil is now down to $43 which is nearly 15% lower than its recent high of 10 days ago!

The problem is OPEC and those outside of OPEC agreeing to production quotas.  As you may suspect there are very good reason why these types of agreement tend to breakdown -- the incentive for cheater is just too great.  If everyone agrees to certain production levels prices should increase, but these higher prices are incentive enough to exceed the quotas -- a vicious circle.  Now many have faced lower oil prices and wish to rebuild their reserves.  The proposed quotas will make it difficult to reach those revenue targets -- hence the disagreement on each country's reserves.  It remains that Saudi Arabia, on of the largest producer of sweet light crude, can no longer force the OPEC meeting participants, because in the past for every cut the others took, SA took almost twice the cut.  Thereby incentivizing the market.  However, SA's position is no longer very comfortable, they have been drawing on international reserves and the Kingdom even borrowed on the international debt market -- its cheaper and easier than liquidating assets.

It remains that the game has changed, the North America market is largely self sufficient -- with the addition of Canada's production the US is about 90% self sufficient in oil & gas production, reducing its incentive in being involved in the proceedings.

Moreover, the American's oil independence position makes them less certain of what is good for the country:  low or high prices.  nevertheless the lower oil prices are seen as a stimulant to the economy.  For Europe the lower oil prices has also resulted in stronger Europe (from 1.09 to 1.12 to the US dollar).

MY point is the following:  Playing the energy complex is very very hard, and most will lose money since its a zero sum game, and there are substantial transaction costs.  When I talk of ETF or other financial product one of the key ingredient are the transaction cost, and the information costs.  They can be horrible and can destroy the economics of a transaction.

In case of the E&P sector (energy that is) the information costs are high because it takes a multidisciplinary understanding of the drivers of the energy sector; not only variation in consumption but to understand the complexity around distribution, production and political aspect of the segment.  Moreover, these "known" aspect change and the very high price elasticity (and small change in the demand or supply will have a disproportionate impact on prices) then bets are difficult.

That's not to say that you should stay out of the energy complex, rather you need to understand your potential for earnings, your timeframe and take into account information costs and transaction costs.  If a week ago you had bought some  3 month dated out of the money options on the oil price (WTI) then the value of these option is today very low -- actually lower than what you paid (although not zero) because if the price of oil dropped by 15% in 10 days it can go up by that amount in 10 days too.  The high volatility makes the investment risky and very poor TODAY, but it doesn't mean its a terrible investment (it would have been cheaper to buy such option today).

Instead if you had bough shares in a service company the impact would be lower, or even better if you had bought an oil ETF (even lower transaction costs), these are all option when today the value of your investment would have fallen, because oil prices are volatile -- it may be that at 15% drop in oil price you liquidate your ETF or your service company investment -- because the mark of a good trader is the ability to see when a position is simply bad and must be terminated.  An excellent trader will have maybe 50/60% of his trade make money.  His ability to cut his losses early is what makes him and his institution money (in the pre-HFT environment).

Anyway these are my thoughts


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