Crude Realities of a Hot Commodity

Sarah Palin’s $150,000 wardrobe caused a commotion, but oil’s $150 makeover, rapid rise to fame and fortune, and sudden recent decline is equally sensational.

In 2003, oil was that awkward guy in the corner at $25, lonely and undervalued. By 2008, the barrel re-emerged refined and glorious.

Conflict in the Middle East, US Dollar weakness, the competition to own the largest SUV possible, a couple of hurricanes, an outrageous call for a “super spike” and petroleum in any form was literally the next hot commodity.

From heating oil to gasoline, olefins to aromatics, traders coaxed oil out of the corner and into portfolios. Commodities tended to have a negative correlation to equities market. Thus oil derivatives provided an attractive means by which to diversify a portfolio.

Corporate players too, employed derivative instruments to hedge exposure to underlying physical commodities. As oil rose and cut further into the bottom line, demand for commodity derivatives products intensified. Companies explored complex trading solutions and exotic products in thin or illiquid markets.

Then oil peaked.

Since peaking at $147, Oil has relinquished nearly $90 almost as sharply as it rose. Commodities players are scrambling again, this time off the dance floor.

Diversified Institutional Investors, in efforts to meet margin calls or keep non-commodity portfolios afloat, began liquidating oil positions months ago while oil was rich and liquid. But with the sharp daily declines in oil, this strategy isn’t likely to prevail. Furthermore, liquidation of oil portfolios and an exodus of “smart money” builds the momentum of oil’s downward spiral.

No longer able to lock in at attractive forward rates, Corporate industrials may have begun exploring strategic operational changes in response to rising costs of operation direct and indirect to oil. Industrials may be shutting down factories, closing production lines, and developing innovations to circumvent fuel/commodities inputs. These changes to future operations and products are moves that could have longer-term oil demand destruction implications which will further sustain falling prices.

Even the oil majors, the easy targets of “excess profits” accusations, are doubly feeling the pain. As a result of impact of oil’s fall from grace coupled with the credit crisis, capital expenditures may outpacing capital inflows. That certainly doesn’t sound like excess profits to me. While the value of oil pumped from the ground declines as oil pulls back in the market place, the cost of financing projects increases as the credit environment continues to worsen.

Uncertainty across capital markets impacts the cost and available liquidity sources. If the capital market liquidity window closes further, drilling in the following years may be significantly revised lower as projects lacking funding do not come to fruition.

Another limiting factor to future production, the Organization of Petroleum Exporting Countries is keeping a close eye on oil’s decline. On October 24th, concerned about oversupply in the face of global slowdown, OPEC released the following public statement: “Oil prices have witnessed a dramatic collapse – unprecedented in speed and magnitude – falling to levels which may put at jeopardy many existing oil projects and lead to the cancellation or delay of others.”

But even the organization’s decision to reign in 1.5 million barrels per day seems to have done little to stop oil’s slide.

Clearly, dropping oil prices have a very tangible result for the every-day American consumer. As prices move towards $50, $3.00 gasoline looks like a steal, heating costs should be lower this winter, food prices globally should decrease, shipping costs should contract and even airfare should pull back.
Just about every cost one can imagine should in theory decrease as fuel prices decline. But then again, isn’t this a symptom of recession?

In fact, fuel prices gave up an additional 9% in response to the most recent report from Institute for Supply Management (ISM). At 38.9, the manufacturing index is well below 50, a level generally accepted to signal economic contraction. The last time the index dropped this low the US was in the midst of recession in the third quarter of 1982.

The prospect of a recession may send market players fleeing like a bad song scatters a packed dance floor.

Not to be a glass is half empty kind of gal, but unfortunately, not all American consumers will be able to take advantage of dropping fuel prices. In fact, the dropping oil and gas prices will have an unpleasant downside for some homeowners in the North East this winter.

When oil continued to surge through the summer of ’08, consumers in the North East panicked after last year’s record heat costs. Many chose to lock into fixed rate heating oil contracts to protect themselves ahead of the threat of another price spike in the Winter of ’09.

Since Peaking, Heating Oil has given up over 50%. However, consumers who entered into fixed-rate contracts near the highs will be locked into high prices to heat their homes regardless of easing heating oil price activity in the market.

But don’t cross oil off your dance card just yet. Though the Recessionista may have replaced the Fashionista on the dance floor, in this volatile market, the potential for oil to make an encore performance seems quite plausible.