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A Slick Situation

Many years ago when I was in college, my family was contacted by a major oil company. They asked if we would be willing to have an oil well placed in the middle of our property. We had 10 acres with nothing on it that we rarely visited. Each member of the family owned an equal share of the property. They contacted all the surrounding property owners also. They offered each owner a portion of the profits from the well. Since the well was in the middle of our property, we got the largest share of the profits. My family had no idea what a good offer was, so we just took what they offered us.

Shortly after we signed up, the checks started coming. That was really great for a college student. I was paying for college myself, so every little bit helped. It was not a lot of money, but it still helped. I looked forward to the check each month. The amount varied a little each month but they came each and every month, until they didn’t.

I called the oil company, and they told me they had not taken any oil from our property the previous month because oil prices were too low. I would not be getting any more checks until oil prices increased enough to make it profitable. It seems that oil stores in the ground really well so they would just leave it there until it was profitable to go get it and sell it. That was my first lesson on oil fundamentals. Oil companies will not pump oil when it is not profitable. There is a cost to pulling oil out of the ground and getting it to market. When oil prices are below that cost, they will leave it in the ground. That will reduce the amount of oil offered to the market. Supply and demand takes over. Reduced supply and prices have to rise if demand stays constant or doesn’t drop as much as supply.

Now, I am just guessing here but from what I have heard, oil from different places, the gulf, Texas, Ohio, Pennsylvania, Alaska… have different costs. So I am assuming that as oil prices fall, various sources start to drop from the market. As oil prices rise, those sources return to the market. As supply increases, the price should find a top. The price at which supply and demand cross.

The US has a strong appetite for oil, but we will reduce our consumption as prices rise. When oil prices are high, we tend to buy hybrids. We try to reduce our consumption. When oil prices are low, we buy SUV’s and don’t worry as much about our consumption. So we help control supply and demand.

There are a bunch of reality shows that show the impact of price on supply. With gold at well over $1,000/oz, there are people all over the world mining gold. The same is true for oil. With oil prices high, people will drill in their back yards for oil. So as oil prices rise, individuals and oil companies bring their higher cost oil to market.

Oil prices are also impacted by speculation. When there are tensions in areas that are large oil producers, oil prices will rise on speculation that supplies with drop and prices will rise. If speculation can outpace supply, prices will continue to rise. If supply is not reduced, once the speculators run out of money, prices will drop, and they will drop below the typical base. Yes, they will drop below cost because speculators have to sell even if it is at a loss. They reduce the amount they will lose by getting rid of the carrying costs. Storing oil in the ground is cheap, storing it in tankers is not.

So how do I know the limits of oil prices? I do not, but I can get close. As I wrote about in several blogs this year, I use technical analysis. Technical analysis helps me determine just how high oil will go before supply rises to stop it and just how low it will go until supply drops to support it. With that information, I can trade the limits of oil prices very successfully. If you want to know how that is done, come on in.

Ken Bailey
OptionsANIMAL Instructor

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Ken Bailey

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