What to Make of the Surge in Oil Prices

By: Money_Morning

Dr. Kent Moors writes: There are a few historical figures I greatly admire, even though I have pronounced personal problems with some of their opinions.

Winston Churchill leads the list.

On November 9, 1942, Churchill uttered these famous words at a London luncheon: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Churchill was, of course, addressing a turn in events during World War II when at last England could have faith it would survive the initial onslaught.

Now, what’s happening with oil prices these days certainly pales in comparison.

But after the big jump in oil prices yesterday I could not help but recall these famous lines…

Oil Prices: The Best One Day Performance Since 2012

After dropping in the morning (once again over concerns about rising inventories), oil prices rebounded in a big way. Crude oil prices surged yesterday afternoon, posting their best one day performance since 2012.

West Texas Intermediate (WTI), the benchmark used for trading futures contracts in New York closed at $48.48 notching 5%+ gain. Brent, the London benchmark, climbed 4%. Even RBOB (for “Reformated Blendstock for Oxygenate Blending”), the gasoline futures traded in the NYMEX, jumped by almost 6.5%.

All of this occurred in a market with oversupply concerns still unresolved and a continuing host of short artists poised to pummel futures prices at any opportunity.

So, if the environment remains essentially the same, why the rise in prices?

The increase – which should give some back to the market today -which has continued into this morning – is a good example of the trading friction I have discussed on several occasions. Yesterday, was the last day of a near-month futures trading period. The market (at least in New York) will now calculate the price you see every day to March 2015 futures contracts starting today.

Yesterday, also marked the last day for options on the February futures. This aspect became a bit more important as oil prices began to move up.

As I’ve noted numerous times, short plays have added to the downward trajectory of oil. As of Friday last week, I estimated that about $6 per barrel of the price was represented by the shorts.

Put another way, short contracts represented about 35% (London) to 45% (New York) of the discount to a more genuine market price. The remainder could be attributed to the “herding” mentality among wider aspects of the market.

Based on actual market dynamics, the price per barrel ought to be closer to $62 in New York and about $65 in London.

Now there is almost always a discount to the “genuine” price. Otherwise, traders wouldn’t be able to arbitrage between “wet” barrels (the oil being sold) and “paper” barrels (the futures contracts written on the real oil).

Nonetheless, the short positions are a much higher portion of the discount in the current environment than the corresponding premium caused when prices are accelerating beyond what the market fundamentals would warrant.

For example, when prices were over $100 a barrel last summer, those holding long positions contributed, on average, about 20% to the inflated price in New York and closer to 24% in London.

Of course, those trading in futures contracts need to hedge their positions against volatile changes in prices. Options are used for that very purpose.

The futures contract is an obligation that requires the trader to acquire a specific amount of oil at the contracted price at a specific time (the contract’s expiration). In contrast, an option provides the right (but not the obligation) to acquire the commodity at a different price.

To hedge against moves against the contract’s strike price, a trader will acquire options for either a higher or lower price. If the underlying futures contract moves “out of the money,” the trader exercises one or more held options to offset the loss.

If the options turn out to be unnecessary (if, that is, the resulting price as the contract approaches expiration is acceptable), the trader allows the options to expire and sacrifices only the small charge for acquiring the option to begin with.

Options can be acquired for any range above and below the futures contract. In our (very) simple example above, today’s traders are poised for prices to go lower. That means most of the options will be pegged in that direction.

The Truth About Oil Prices

Which brings us back to the brunt of what happened to oil prices yesterday. On an options expiration day, any move up in a price – that most had “bet” would be moving down – required an immediate covering of the shorts (that is, the options pegged to a continuing down move) by “bets” in the other direction (which can then be rolled over under the new near-month futures contract). That merely accentuated the acceleration in price.

You see, between the futures contracts and options, and between various options themselves, exists a complicated and multi-layered realm of derivatives and swaps. As a result, we will continue to see the ripples of these settlements (some looking like square pegs being shoved into round holes) for several days to come.

One of the interesting results of this shift will be a closer parity between WTI and Brent.

As the spread narrows, it is likely to have a modest upward pressure on prices in New York. But at the moment, that will only be of marginal consequence. It will have a more important consequence as oil prices stabilize and begin to rise even further. (As I noted, last week, that is now the opinion of most major petroleum economists).

However, to put matters in perspective, yesterday’s surge merely brought prices back to almost the exact level recorded last Friday. Point being, this is still an ugly market.

And that reminds me of another one of my favorite Churchill utterings.

There are two different versions of the circumstances surrounding the quote depending on which story you hear. It was either directed to the socialist MP Bessie Braddock or the Conservative Lady Astor, the first female MP in the history of the modern English Parliament.

When accused by one of them of being “disgustingly drunk” the Conservative Prime Minister responded: “My dear, you are ugly, and what’s more, you are disgustingly ugly. But tomorrow I shall be sober and you will still be disgustingly ugly.”

Ouch!

Source : http://oilandenergyinvestor.com/2015/01/make-yesterdays-surge-oil-prices/

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