Keep in mind that if the person answering the question happens to make a living in part by making such predictions, likely a jargon will develop over time that may make complex rationales seem that much more complex; especially in the case of a global commodity (crude oil) where its price is subject to innumerable market forces from around the world. Unfortunately, the use of complex terminology is for some people an effective way to hide the fact that they really don’t know what they are talking about.
For instance, you may hear answers that include explanations involving phrases such as positively skewed asymmetrical risk/reward profiles, or acute bearish downside drivers. If this is the case, you wouldn’t be remiss to wish you never asked the question in the first place. But it is important to remember that although you may not speak a foreign language, you should not immediately discount the person who answers such questions in what sounds like the Greek or Mandarin or Latin language. It may just mean you need to bone up on some terminology.
In investing parlance, an asymmetrical risk/reward profile is a situation where an investor’s gain realized from the move of an asset in one direction is significantly different from the loss incurred from its move in the opposite direction. If investors were to look ahead six months and say “there is a 40% chance that the price of wheat will go up 30% vs. a 20% chance the price will go down 10%,” the price of wheat for these investors has positive asymmetry.
That said, and as the title of this article suggests, if I were to be asked whether the price of crude oil is going to go up or down anytime soon (as I often am) I would give the following answer: Odds are…Up.
Ready for why? Read on to find out and hopefully you won’t come away wishing you never decided to actually read on.
But first, let me say that I am aware enough to know that there are people in this world far better to answer the oil price question than myself. For that reason, my answer to the question is in actual fact someone else’s answer – I am simply relaying it because I think it is a persuasive argument from a trusted source.
That person is Michael Tran, Director of Commodity Strategy at RBC Capital Markets. Despite his occasional use of complex jargon, Michael Tran has proven time and again that his observations on the oil and gas market are both insightful and well reasoned. In any event, Tran thinks the price of crude oil is more likely to go up than down in the next several months. That is not to say that he thinks it will not go down, but rather, the odds are stacked in favour of a price increase. As he noted in a recent letter to his clients “[the price of oil’s] risk/reward profile appears asymmetrically skewed to the upside as improving fundamentals begin to overrule the recent weak sentiment.”
His conviction, as of mid August, is broadly supported by the following three factors:
If after reading the above list, you don’t feel any more enlightened as to why Tran thinks prices will rise, consider the following revised list. It is my attempt to write in plain(er) English, the above three factors:
Now let’s briefly go through each point to see how each gives the price of oil – using everyone’s favourite phrase – a positively skewed asymmetrical risk/reward profile.
People who make a living guessing where the price of oil is going have a tremendous read on current events and factors that historically influence the commodity’s price direction. Their work involves tedious research and the ability to analyze data points akin to reading subprime mortgage bond prospectuses. And so what Tran is saying in the first point, is that for right now, the broader market generally hold a consensus as to what the significant downside risks are that face the price of oil.
When a risk is identified and communicated at large, generally the market responds by balancing out any new buyers and sellers in light of the information. If a risk factor were to actually pan out, and from seemingly out of the blue, you can imagine there would be a collective surprise in the marketplace; either the price would rapidly rise or fall depending on the degree of risk and how underappreciated it was within the market. Author Nassim Nicholas Taleb popularized the concept of a ‘black swan’ event in finance. This is when large risks go largely unseen by the market, and that when they materialize, substantially alter the price of a given asset.
For the second point, Tran indicates that there will an upward swing in the price of oil because, to him, the market has yet to correctly account for positive data concerning oil’s fundamentals. As was recounted in an earlier article of mine, Tran believes the market is quick to react to weekly US data releases while developments in other parts of the world can remain unearthed for months. In this case, there has been marginal drawing of crude oil inventories in developed countries other than the United States. This suggests that gradually, the supply overhang that has kept prices as low as they are is abating.
The third point is fairly straightforward. In the past several months, data has shown that there has been a higher than average number of short positions taken against West Texas Intermediate – the North American benchmark for the price of crude oil. The high number of shorts indicates that many investors seem to think that the price of oil will go down and are willing to bet on it.
But Tran is suggesting that for many of these shorts (there will almost always be shorts in a market) they have yet to take into consideration all of the relevant information as he has. Once they do, surely (the thinking goes) they will reverse their course of action and bet oil prices will rise. As for when this occurs, that is too difficult to say. Tran simply wants to point out that the downward pressure caused by lots of investors thinking bearish thoughts about oil will soon let up. When it does, the price of oil will likely rise as they go about buying, rather than selling, a barrel of oil.
It is important to note that in spite of the the above three points, events could just as easily occur in the world that would cause the price of oil to decline. The point is that these events remain unlikely. Is it possible that peace is found in the Nigerian Delta, thereby releasing Nigeria’s many shut-in barrels of oil back into the market and thereby causing a downward price movement? Yes. Is it likely? No.
And so may I remind you that yes, with all things considered, I do happen to believe that, sooner rather than later, the price of oil will definitely maybe go up.
But…you never know.