Explainer: what determines the price of oil and how it impacts ASX small caps
A lay person’s guide to what is meant by ‘oil prices’ and how they affect ASX small caps
To oil investors, what matters most is that their company finds oil.
But for the oil companies, discovering oil is just the start. They will want to on sell the oil or perhaps the property to another oil company. And the higher oil prices are, the higher the return will be.
It follows from this that the higher oil prices are, the more appealing oil exploration becomes.
However, even though the oil market is driven by supply and demand, numerous factors relate to the oil price that are completely irrelevant to the quantity or quality of oil discovered by oil companies – including ASX small caps.
Yes, this is another ‘explainer’ article that aims to help investors understand the complex workings of the ASX resources sector.
Oil is arguably the most critically important substance in the global economy because oil is energy. It powers cars and planes, generaes tar, asphalt, ethanol and biodiesel – even kerosene.
Crude oil alludes to the thick liquid generally but unlike gold (which when extracted is essentially the same product) there are different types of oil with different concentrations and sulphur.
Generally, when oil companies, the media and other stakeholders (such as airlines) refer to ‘oil prices’ they are not referring to the price of oil itself (the ‘spot price’). But since the oil crises of the 1970s (the most significant of which, in 1973, was caused by an OPEC embargo), oil traders have engaged in trading futures rather than crude oil itself.
Oil futures are agreements to buy and sell crude oil at a pre-determined rate.
Uniquely in oil futures, traders will agree on the drilling location and quality of oil. In doing so, they can protect themselves from sudden price fluctuations although, inevitably, they look to the same factors than if they were engaging in spot oil trading.
Brent crude is named after oil fields in the North Sea in between Britain and Scandinavia where initially this oil came from. Today it comes from multiple fields in the North Sea.
Brent oil is considered the best in the world because the oil is light and sweet, hence useful for multiple refining purposes. Furthermore, being at sea it is easy to transport on oil tankers.
For all these reasons, Brent has been the dominant benchmark since 2012, even though it is a very small portion of the world’s oil.
WTI (West Texas Intermediate) alludes to oil extracted from US wells. While the product is just as ideal for gasoline as Brent, it is difficult to transport to refineries, being land-locked. This is mostly done through pipelines, but these have to be extensive for the oil to be accessible.
Since 2012, WTI has usually been slightly cheaper than Brent although at present there is a significant gap ($11).
There are other indices, based on specific locations such as Tapis (Malaysia) and Urals (Russia). China launched its own benchmark – the Shanghai crude futures.
The most commonly used of ‘the rest’ is the Dubai Crude. The Dubai crude is often argued to be the ‘third oil marker’ and is most often used for Asian exports because of the availability of UAE oil. Yet the Middle Eastern region is dominated by state owned companies that curtail competition, hence there is less commodity trading.
Many media outlets only allude to Brent and WTI.
Oil traders will trade futures contracts every day and will seek to make money either way the price of oil moves. There are specific market strategies that allow traders to make money either way such as straddling whereby traders buy differing options at a strike price (not the price of oil, but a smaller price whereby if oil prices move in either direction, they will profit).
Oil traders will watch news from oil producers (particularly the Middle East), production numbers and the global economy critically and make decisions quickly.
One utilised resource is the EIA Weekly Energy Stocks Report. It will give traders analysis not only on crude oil for that week but refined products (such as gasoline) and their usage.
What about OPEC?
OPEC – The Organization of Petroleum Exporting Countries is an alliance of 15 oil producers, most of whom are in the Middle East or Africa. Although they only produce 44% of the world’s oil, they have more than 80% of reserves. Among its members are Iran, Saudi Arabia, Venezuela, the UAE and Qatar.
For many years Saudi Arabia were the world’s largest producer but the United States (who are not an OPEC member) took the mantle in September. Additionally, Russia have acted as a ‘de-facto’ member through working with OPEC to set production targets.
Such moves not as radical as the embargo of 1973 but these can occur suddenly and have a significant impact and this was the reason why oil traders moved to trading futures rather than crude oil.
The direction of oil prices
From early 2016 until early October 2018 oil prices (particularly Brent and WTI) were rising and and were expected to continue to rise. Some analysts and journalists predicted oil could hit $100 per barrel by years’ end. This was because of declining oil production in most major producers.
In November 2016, OPEC and Russia cut 1.8 million barrels of oil per day and renewed this in November 2017. Additionally, certain countries in OPEC (Venezuela, Nigeria, Libya and Iran) cut production further. The forthcoming US sanctions on countries importing oil from Iran also played on oil traders’ minds.
But since early October 2018, oil prices have retreated by over 20% – with the WTI falling from US$77 to US$55.69 and Brent Crude from US$86.29 to US$64.91. This is was due to unusually high levels of US production (over 11 million barrels per day – nearly 300,000 more than analysts expected), the US granting exemptions to eight countries to continue to import Iranian oil (albeit temporarily) and investors turning from oil towards natural gas as colder weather begins to hit the Northern hemisphere.
Additionally, the global stock rout in October did not help oil’s cause.
OPEC will meet next on December 6 in Vienna and despite the urgings of US President Donald Trump it is expected they will announce further production cuts which may see prices rise even with the current market conditions. Given the geopolitics and volatility of oil prices, businesses in the oil industry are always watching oil prices carefully Whilst some oil-reliant industries such as transport and automotive are phasing out oil this is occurring too slow a pace mean that the global economy would be unaffected by oil price wings.
What does all this mean for ASX oil juniors?
Although higher oil prices will not be good news for oil-reliant industries such as airlines, higher oil prices will be good news for ASX oil juniors. Higher oil prices will mean their projects will be more profitable. Oil is expensive to extract, and companies will want to generate a return on their investment.
The higher oil prices rise, it is usually the case that the higher profit they will generate. Of course, it is most important that oil is discovered. Yet if oil is higher not only will shareholders of existing companies gain higher returns but there will be more opportunities, for current oil companies will be encouraged to expand their exploration and new oil companies will emerge.