The Very Long Term View for Energy Trading {Unit 03}

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Unit-3

Fundamental Analysis

Overview

This chapter examines crude oil prices from the perspective of two fundamentals. Oneis supply-and-demand balance and the other is a geopolitical factor. They are the basicfundamentals of crude oil price. This fact is straightforward to understand: Supply-and-demand balance largely dictates virtually all commodity futures price. While the strategicrole of oil for almost every country determines that oil price is bounded to be tied tightlywith the geopolitical factors.Few will argue that the recent decades are interesting times for energy industry. Thisobservation is true for both traders and investors. On the traders' side, for example, thederegulation of natural gas in the United States in the early 1990s is slowly butinexorably moving into Europe and Asia. Natural gas deregulation has strongly fosteredcompetition, as well as called for needs for risk management. On the investors' side, asignificant phenomenon is that for many of today's hedge funds, commodities were thehot tickets from 2000 to 2005, as their prices began to rocket, fuelled In reply to: largepart by China's boom."Unlike oil, gas can't readily be moved about the globe to fill local shortages or relievelocal surpluses. Forecasts of freezing U.S. temperatures in winter or heat andhurricanes in summer can send prices jumping, while forecasts of mild weather can dothe opposite. Last December, amid a cold snap, gas soared to a record 15.378 a millionBritish thermal units on the New York Mercantile Exchange, or Nymex. This month,prices fell below 5 in the absence of major hurricanes and with forecasters talking aboutanother warm winter. Yesterday, gas for October delivery settled at 4.942 a millionBTUs on Nymex, off four cents."

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Speculative Activity

EIA analysts believe that the change in the relationship between prices andOrganization for Economic Cooperation. The wholesale price spread is the differencebetween the wholesale price of gasoline and the spot price of crude oil. andDevelopment (OECD) commercial inventories is related to changes in the level ofsurplus production capacity, which declined sharply due to the acceleration of global oilconsumption growth in 2003 and especially in 2004. Available evidence suggests thatincreases in speculative activity in futures markets are a result of the high level ofcurrent oil prices and the high uncertainty surrounding the value of future oil prices, notthe other way around. In times of ample spare capacity there is little motivation forcommercial producers and users of energy to shed risk, or hedge, since there is littleperceived risk. With little desire to shed risk, there is only a small role for those whowish to take on the risk, the speculators. In contrast, when excess capacity declined andmarket participants perceived that OPEC members would no longer maintain stableprices in the environment of geopolitical risk, market participants became increasinglyless certain of the path of future oil prices. The increased uncertainty regarding the pathof future oil prices has caused commercial producers and users of energy to increasetheir desire to hedge. With the increased desire to shed risk, there has been a muchlarger role in the market for those prepared to bear this risk, the speculators. Althoughchanges in the net position of non-commercial participants in WTI futures contractsappear to be in relation to changes in WTI spot prices in the very short run, the overalltrend of increasing WTI spot prices is independent of the participation of speculators inthe market.

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Figure 5

: Net position of Non –Commercial Participants

Source : NymexEIA believes that the shift in the relationship between prices and OECD commercialinventories is better explained by changes in the level of surplus production capacity.OPEC’s change in behavior that came as a response to the Asian financial crisis andoverproduction in the face of lower demand, shifted crude oil to a new price level.Production restraint by key OPEC member countries shifted the price base while marketparticipants simultaneously perceived a growing likelihood or risk of increasingly scarceincremental crude oil supplies. Futures market long-term contracts shifted up to a new,higher, level of roughly $30, reflecting these new long-term expectations. Still, inventorylevels and crude oil spot prices continued their inverse relationship (i.e., fallinginventories correlating with rising prices), as shown by the January 2000-April 2004trend line. Beyond April 2004, there is an apparent reversal in the price/inventoryrelationship. While the correlation is not strong, prices appear to increase withincreasing inventories, as shown by the May 2004 to March 2006 trend line . This factalone appears confusing to some observers, who may attribute this shift to the activityof speculators.Several different factors have caused the increase in crude oil prices since 2002. Thedisconnect between non-OPEC supply growth and rising demand growth has raisedproduction expectations from OPEC suppliers at a time when geopolitical uncertainty

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