If you look toward the core of energy markets, you will undoubtedly see oil. With improved levels of transparency, investors and oil market professionals are afforded a top-down view of what is happening - a fact that will become more prominent as more over-the-counter business flows through clearing houses.
Oil as a portfolio investment is a relatively new phenomenon.
Historically, crude oil has been traded by professional traders in the energy industry with years of experience, often starting in an entry-level job at a major oil company. But oil as an investment began in the 1980s when investment banks began to see it as a profitable asset class and advanced further with the advent of crude oil futures on the New York Mercantile Exchange, now part of CME Group. Financial traders who were not schooled on physical oil markets understood trading futures, and the exchanges provided a baseline upon which to begin.
And today the refrain in the crude oil markets is simply this: "Oil is money. It is a currency like any other."
In the 1990s as global demand was on the rise, hedge funds looking for fresh alpha were drawn to oil and commodities. Meanwhile, key nations were heavily influencing prices. China, in its run-up to the 2008 Olympics, was using and stockpiling oil in unprecedented quantities.
Add the recent explosion of exchange-traded funds (ETFs), and retail investors suddenly were positioned alongside the professionals. The oil-as-investment approach came to fever pitch when West Texas Intermediate (WTI) crude oil futures hit an all-time high of just over $147.27 in the summer of 2008.
Since then, crude oil has not strayed far from the investor spotlight. It again surpassed $100 a barrel early in 2011 when protests in Egypt, Tunisia and around in the Middle East began to worry traders. Those taking long positions in physical oil had already pushed North Sea Brent prices far higher than WTI - a switch from the $3 "normal" spread late in 2010.
Time and Tide
Higher oil prices frighten equities markets and economists alike due to the fragile nature of the economic recovery. Consumer spending, for a start, would suffer if gasoline topped $4 a gallon again. But things are different this time, says Walter Zimmerman, vice president and chief technical analyst at energy analysis firm United-ICAP.
"There are issues in 2011 that did not exist in 2008 when crude oil topped $147 per barrel," Zimmerman says. "We don't have increasing real estate prices today, and in 2008 we didn't have chronically high unemployment. Also, we no longer have unlimited credit. There are serious clouds over the market now."
According to Citi Futures Perspective, the fundamentals are indeed quite a bit weaker than in 2007-2008. U.S. petroleum inventories as of Feb. 11, 2011, covered 56.5 days of four-week average demand, for example, an uptick from the 55 days of coverage a year earlier and 4.6 days above the five-year average.
OPEC, which held just under a million barrels per day of spare capacity in July 2008, now has 4.65 million barrels per day of spare capacity, according to data from the U.S. Department of Energy's monthly Short-Term Energy Outlook. So growing investor interest may push prices higher, but without a tighter physical market to support it, crude oil will not be a true bull market, says Tim Evans, energy analyst at Citi Futures Perspective.
Zimmerman likens the current mood to the tides. "The collective mood of the market is like the underlying ocean, with the tides being major peaks and troughs," he explains. "Major peaks are where everyone is bullish and major troughs are where everyone is bearish. We are at a bullish excess currently. We won't be able to hold onto $100 crude."
Treating a physical commodity as if it were a financial instrument has given oil markets a dramatic boost in volume and volatility. Zimmerman calls it the "financialization" of oil.
"Crude oil became financialized in 2007 when the stock market and commodities collapsed and investors became intensely aware of deflation," he says.
Not everyone believes the financialization of oil is a good thing. Evans is more of a traditionalist on this point because oil is not something the average person can store like stocks or even gold.
"The threat of physical delivery may not be so much of an issue when it's a matter of putting a few gold bars under the bed, but not many futures traders are really equipped with a backyard oil storage tank," Evans says.
Plus the buy-and-hold nature of commodities investment can lead to market anomalies which in turn lead to fears over speculation. The Brent/WTI spread, for example, is indicative of the financialization of oil, and has only become an issue in the past few months.
"In my view, the wide Brent/WTI spread is a market distortion that has been created by trade flows - money managers attracted to the Brent market's stronger calendar spread structure and stronger price momentum have chased that market higher," Evans says.
The Brent/WTI spread blow-out from a "norm" of $3 to roughly $14 also raised a debate about whether WTI remains a viable benchmark for crude oil. Some analysts and academics have called for a study into a more viable benchmark, but traders and industry pundits are nonplussed.
"The criticism of WTI as a benchmark came during extremes in the Brent/WTI spread," Zimmerman says. "It is easier to blame the underlying system than to blame your own trading decisions."
Open interest for WTI remains nearly three times that of Brent. And WTI production is increasing while Brent has peaked and is dwindling. A new pipeline running between the United States and Canada will mean that WTI becomes even more fungible and that Cushing, Okla. - the contract's point of delivery - becomes even more of a center for oil. The pipeline will be able to carry between 150,000 and 200,000 barrels per day from Canada to Cushing. CME Group, which launched the Western Canadian Crude Oil futures contracts last July, opened an office in Calgary in 2010 to be closer to these markets.
Panning for Alpha
The collapse of the credit bubble sent investors scrambling into the marketplace to find new areas of profit-generating asset classes. Oil became one of them, attracting investment from hedge funds, big banks and ordinary investors. No longer is it solely the domain of refiners trying to balance their crude slates.
Evans notes that investment demand - including ETF and index fund investments - has certainly been a big part of the rise in oil prices. Commodities, historically, have trailed behind the equity markets when exiting recessions, due to high stocks and surplus capacity that take time to work off.
"In the current cycle, we still have the typical high stock levels and relatively high OPEC spare capacity, but prices have snapped back to the upside due to the investment demand story," Evans says.
In other words, investors are willing to overlook high oil inventories with the assumption that the market will tighten eventually. ETFs and long-only funds deploy largely buy-and-hold strategies, which can add to upward pressure.
Fortunately, in oil markets, transparency is improving steadily, allowing investors and oil market professionals a top-down view of what is happening. The Commodity Futures Trading Commission, for example, has bulked up its reporting over the past two years, revamping its Commitments of Traders Report with more specific categories. And as more over-the-counter business flows through clearing houses, participants will be able to see even more of that side of the market.
"We now have a clearer view than ever of what goes on in the futures and options market," Evans says. "There may still be some dark corners around the wider global market, but there is growing interest, both in the United States and internationally, in tracking and understanding trade flows."
As that information flow continues to reach more people, experts say, the diversity and number of participants will likely grow as well.