Sunday, January 31, 2016

Balancing The Crude Oil Market

One of the most fundamental economic questions about markets and their interworkings surrounds the theoretical concept of an equilibrium. For mathematical economists, the question may seem weightier indeed, but for the run-of-the-mill topographical observer, the phenomenon can play a role in the everyday decisions of an investor and a consumer. Equilibria exist in all systems. One of the most popular may be studied by a physicist concerning pendulums and Newton balls, but to an economist, the forces of supply and demand, price and quantity come to mind. As a quantifiable framework, price and quantity can be shown by two sets of equations and set equal to each other. In the same way, investors can abstractly think about the amount buying and selling going on in the marketplace, knowing that intraday trading is just another method of finding the equilibrium.

Many weaknesses pervade the type of static equilibrium analysis that we employ. Who really knows if the equilibrium that we just calculated will be applicable to the immediate present? There's a Shrodinger's cat kind of evanescence that defines the problem. A mathematician can never adjust his calculations for each immediate change in the economic situation, and a trader will never be able to buy and sell at the right equilibrium because of how fluid the market is. The question I have always asked is: where is the equilibrium in oil price? Is that price given to us my the market? When looking at values determined by large groups of individuals trading, one has to discount (or premium) the sentiment that affects their peers. Just like an auction, each player has a perceived price which he or she thinks is optimal. An investor who wishes to "bet" on the crude oil trend would have to decipher a plausible equilibrium based on the perceived value determined by the millions of other traders out there. So what should that trader base his projections on, his peers' thoughts or the supply and demand forces that come into play? This depends on what that individual thinks is driving daily market fluctuations.

What can be said, then, about the recent performance of the crude oil indicators? This week, crude oil has been on the rise after the early months of January saw some of the lowest prices in recent history. The West Texas Intermediate price has grown about 3.17% in the past five days despite a -12.99% loss for the month. When thinking about supply and demand forces, one might postulate that a significant weekly gain might represent a change in fundamentals where the equilibrium has shifted to show either larger demand or smaller supply. Weekly production estimates show a small drop of 14,000 bbls a day by the end of January. At the same time, the first month of 2016 showed an increase of 20,000 bbls a day from the end of 2015. That's an increase of 0.22% supporting losses of about 13% in price over the span of a month. With these numbers, it would appear that the market has not reached a major consensus on what a plausible equilibrium might be. Increased volatility hinders the ability for traders to find an acceptable equilibrium who might take technical signals as points that provide meaning to a balanced market. There may be more forces that need to be accounted for.

Exchange traded funds became a famous process of securitization that transformed the trading floor. Long and short term traders use the tool to take out bets on certain industries or sectors of the market that appear to have an upside (or downside). There are various ETFs that follow the performance of the commodity price of crude oil. While the trading is not identical, it typically follows the same pattern. There is a fundamental difference between those investing in each asset. If one is buying a WTI contract, he obviously has some demand for oil. Either that or the investor seeks to supply that oil at a certain price. Individuals who have these supply and demand concerns would not trade an ETF in order to solve them. Instead, traders who have a feeling or have noticed a specific trend develop might purchase some of the derivative in order to profit from a movement in price. Here, the individual has less of a stake in the actual supply and demand for the product while focusing on the trend and sentiment surrounding the entity on which the entity is based. The chart above tracks WTI spot price over the past couple months with the performance of OIL plotted behind it. Before 2016, there appears to be no difference between the movement of these two securities. The line that represents OIL rarely deviates from the commodity which it follows. Major deviations only occur at the end of 2015 and the beginning of 2016 as volume spikes and price dips. The arrows point to three major differences in the paths of the two tickers. In all three of these instances, it appears as if the OIL fund overshoots and exaggerates the trends that were in play.

Looking at the comparison between OIL and WTI shows a difference between supposed fundamental value and sentimental value. Because one can see more volatility on the sentimental end, it might be possible to classify the current trend as an orientation of attitudes toward the current and future status of crude oil. Equilibrium analysis concerning the supply and demand of the market might be out of focus because of this sentiment-based trend that has apparently emerged. Traders that harness swings of emotion might be more capable of taking profits in this month and the near future, But remember, equilibria are only snapshots of the current desired state of the market. With more news and fundamental change, both the sentimental equilibrium and price-quantity balance will continue to develop. For now, the crude oil might be a little oversold and with a little bit more time, will experience a small rebound as fundamentals come back into focus.

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