Rational Advisor

This was based on a question asked to me by a teacher of 7th grade students. She was trying to give a simple explanation of why Oil has been so volatile

Katie asked about explaining the volatility of Oil prices.

Here is my short comment on it (as you are aware, there are never any “short” comments from Rana)

Oil is priced on two factors
-Supply and Demand
-Speculation

The base price of oil is determined by Supply and Demand

Less Supply and more demand means that Oil goes up in value and the vice versa

This base is also determined by the marginal cost of production – which mean the lowest price would be the cost of pulling it out of the ground

The volatility in price is predominately a function of speculation (the larger reason for volatility)

Hedge funds were the greatest cause of Oil price volatility over the last three years. Hedge funds use leverage to add to a “hot” sector. This leverage magnifies the return and also the losses. Leverage also meant a larger amount of money was chasing a fewer amount of commodity (oil) contracts – hence the rapid increase in price. The decrease in Oil prices is also because of the failures of these “brilliant” hedge funds. Amaranth, Bear Stearns, even Lehman Bros

Index based funds also were another major cause of the volatility – as the demand for index funds increases – more andmore index funds are created. And in the last two years the demand has been for commodity based index funds – something that was virtually non-existent five years ago. These new index funds have to mimic their indices by buying the underlying commodities. As more index funds are created more commodity contracts are sold – and price increases. Now, as the price of Oil decreases, these index funds also have to match the weighting of Oil in the commodity indexes and sell – so, we get greater volatility on the downside

Speculation around Mid-East conflicts. Since Middle East is a large supplier of OIl, any concerns around stability in that regions leads to speculators betting on commodity prices, mainly because they think that supply will be disrupted. What’s strange is that this often occurs when the price of Oil is low - like $30 to $40. We get some situation happening in the Middle East, usually linked to Palestine and Israel, and oil prices go up. Even though there is no Oil in Palestine or Israel. It’s almost as if the Oil rich countries to keep the price higher, fuel the volatility in the region. After all, a higher oil price does profit these Oil rich middle east nations. The only nations that stand against this conflict and want it ended are Jordan and Egypt (oil poor nations). Otherwise nations like Iran and Saudia Arabia stand back and enjoy the increase in their profits. When prices reach the value of around $65 you see the conflict stop. isn’t it strange how there was no major conflict in the middle east when Oil was above $100.

Currently the volatility due to hedge funds has been flushed out – so we’ve seen a dramatic drop to the $33 level, this is far below production costs. So. We’ll most likely see an upswing to the global base production level around $60-$65 a barrel thanks to speculation now in the Middle East conflicts – which means pump prices should be around 85c a litre.