Investing in oil, crude now traded as a financial asset

2 August 2010 2 August 2010

BonTrade

Oil is no longer simply stuff that fuels our cars and heats our homes, crude oil futures are become a financial asset and investing in oil is in turn becoming more popular.

Oil’s new status as a financial asset shows how large institutions, pension plans, university endowments and sovereign wealth funds are tinkering with their investment strategies. These huge investors have come around to the notion that they should keep 5% to 10% of their money in commodities as a hedge against inflation and as a counterweight to the stock market.

You can condemn this strategy as speculation, rest assured that some US Congressmen will seize the opportunity in the months ahead to do just that, but the reality is a bit more humdrum. Large investors aren’t whooping it up at a casino, trying to cheat the poor consumer. Rather, they’re engaged in the entirely respectable task of trying to buy assets that offset their risks in other areas.

For instance, one major motivation for institutional investors to stock up on oil is fear that the US dollar is set for a long decline. In contrast to the greenback, oil futures are a truly liquid currency, one that the Fed can’t inflate away.

The size of investors’ appetite for oil as a financial asset became clear in 2009, when crude oil prices rocketed from a low of $33 a barrel to above $80, despite swelling inventories and normal demand from end users.

Investors continue to drive the market for oil, pushing prices above $78 a barrel last week and this despite the opinion of no less an expert than King Abdullah of Saudi Arabia, who has said a couple of times over the past two years that $75 to $80 a barrel would do just fine, thank you.

As long as investors enthusiasm for oil lasts, we live in a surreal world in which the fundamentals of supply and demand seem to have lost their traction.

If consumers appetite for energy were the deciding factor, it’s hard to see what would be forcing oil prices higher with the IEA predicting a less than thrilling 1.8% increase in global demand for 2010.

Oil supply seems ample, as well with crude oil inventories in the US are at above average levels, and the futures market is quite happy to guarantee you delivery of oil in 2014 for only about three dollars more than it would cost you to buy a barrel today.

But neither slow growing demand nor the market’s expectation of ample supply for years down the road has been capable of shaking investors’ enthusiasm for oil as an asset class.

“This raises a key question,” says Bassam Fattouh of Oxford University in a recent paper on oil pricing. “If market participants attach little weight to current market fundamentals and if future market fundamentals are highly uncertain, at which price or price range should the oil market clear?”

His answer is that oil prices have become “indeterminate” a professor’s way of throwing up his hands and saying you can no longer predict what’s going to happen next. Oil’s price depends upon a guessing game among major market players in which everybody is trying to guess what prices other players are guessing.

If that is correct, oil investors can expect some neck wrenching swoops in the years ahead as bulls and bears take turns in the pilot’s seat.